Bollinger Bands — how to read and use this volatility indicator?

Two traders look at the same EUR/USD chart. The first one sees a candle closing right at the upper Bollinger band and sells, because "price is high up there". The second one sees that price has been riding that same band for the eighth session in a row and buys, because to him that is proof of trend strength. Same indicator, opposite conclusion — and the only thing that separates them is context. Below I explain when a band touch actually means something, and when it is simply noise.

What Bollinger Bands are made of

Bollinger Bands are three lines calculated from the last twenty candles. A plain moving average runs down the middle, and the other two sit two standard deviations above and below it. Standard deviation rises when the market gets agitated and falls when it dozes off, so the bands widen and narrow on their own. This is not an indicator about the level of price. It is an indicator about the size of its swings.

Simple statistics sit behind that construction. If price changes followed a normal distribution, only about five percent of candles would close outside two standard deviations. The tails of the distribution on the currency market are fatter than that, so touches and breaches happen noticeably more often in practice. A band touch is a relatively rare event, but it is not an extreme one — and on its own it settles nothing.

The squeeze, or a move announcing itself

A squeeze is the situation in which the bands converge because volatility has dropped. Markets breathe: after a quiet spell, a move arrives sooner or later. Narrow bands tell you the spring is loaded. They say nothing about which way it will release.

1. Find a genuine squeeze. The bands should be the narrowest they have been for several months, not merely "fairly narrow" — the band width indicator judges that numerically rather than by eye.
2. Wait. During the squeeze price oscillates inside the bands, sometimes for a dozen or more candles. Entering at that stage is guesswork.
3. The signal is the first close outside a band — preferably a candle with a clear body rather than a lone wick. You enter on that candle's close, because while it is still forming price can easily turn back.
4. Put the stop loss on the far side of the middle line. A stop placed just beyond the band will be taken out by the first expansion, and after a breakout expansion is the rule.
5. Measure the target with the band width from just before the breakout — that is the only yardstick the indicator itself provides.

The bounce works only in a range

The oldest myth on the currency market goes like this: price touched the upper band, so I sell. Bounces do happen, but only when the market is going nowhere and the bands mark the edges of its swings. In a trend that same rule turns into opening one position after another against the move.

The filter that separates the two situations is a measure of trend strength. The simplest one to reach for is the ADX indicator: a reading below 25 describes a market without direction, and above that line you have a trend, at which point bounces stop paying. The candlestick patterns that confirm a turn at the band are covered separately in the piece on the most important candlestick patterns.

Walking the band, when a touch means continuation

This is the mirror image of the bounce. In a strong trend price can walk along one band for a dozen or more candles, touching it in almost every session. That is not a warning of reversal. It is evidence that the move has momentum.

1. Establish direction on the daily chart — a trend shows itself by price staying on one side of the average, not by a single large candle.
2. Wait for a pullback toward the middle line. In a trend that line, and not the opposite band, is where price naturally rests.
3. Enter with the trend after the close of a candle that shows demand returning at the middle line — or supply, in a downtrend.
4. Place the stop loss beyond the last local extreme. A trend that carries price to the other side of the channel has stopped being a trend.
5. Close the position once price spends several candles in a row failing to reach the band on its side. That is the first visible sign the move is fading.

Everything here rests on reading the trend correctly. Mistake a correction for a trend and you will be adding to a move that is already ending — which is why you judge direction on a higher timeframe than the one you enter on.

The most common mistakes in reading the bands

1. Treating every touch as a reversal signal. In a trend a band touch means strength, not exhaustion. Without a trend filter the same rule makes money one month and produces a run of losses the next.
2. Hunting for squeezes on five- and fifteen-minute charts. The bands tighten there several times a day and most of those breakouts go nowhere. A squeeze starts to mean something from the four-hour chart upward.
3. Putting the stop loss just beyond the band. After a breakout the bands expand — that follows directly from how the indicator is built — so a stop left there gets taken out by the very move that was supposed to confirm the entry.
4. Using the bands detached from the chart. The indicator says nothing about direction or market structure. It measures dispersion around an average, and without reading price it remains pure statistics.
5. Tinkering with the settings. The (20, 2) parameters are the standard proposed by the author of the indicator. Values tuned until they look good on history usually describe the past rather than the future.

Band width, the underrated companion

BandWidth is the distance between the upper and lower band divided by the middle line and expressed as a percentage. Volatility is therefore given as a fraction of price rather than in pips, which makes it comparable across instruments and across periods — much like the average true range (ATR), except computed from standard deviation instead of candle ranges.

It has one job: to answer objectively whether today's narrowing really is a squeeze. Instead of judging by eye, you compare the current reading with its own low over the past several dozen sessions. Absolute thresholds are of little help, because a quiet currency pair and gold move in completely different ranges — what matters is the position relative to that instrument's own history. Most platforms carry the indicator in their standard library.

"Tags of the bands are just that, tags, not signals." — John Bollinger, Bollinger on Bollinger Bands, McGraw-Hill, 2001.

What to do tomorrow

1. Add the bands and their width to two charts. Pick the pairs you trade most often, switch to the daily timeframe and scroll through the past year, noting how tightly the bands were able to converge. Without a scale of your own you cannot judge whether today's narrowing is unusual.
2. Record the trend strength reading next to every trade. Before you open a position on the back of a band touch, check ADX on the same timeframe and write it into your journal. After twenty entries you will see whether bounces only pay off for you in a range.
3. Review the last ten trades that were closed on a stop loss. Count how many of them had the stop sitting just beyond a band — that is the quickest way to check whether you are handing money to the ordinary post-breakout expansion.
4. Move on once the three basic situations are second nature. Measuring where price sits inside the channel, working with band width thresholds and combining the bands with other filters are covered in the piece on advanced use of Bollinger Bands, which assumes the material on this page is already behind you.