Bollinger Bands – Profit from One of the Best Trend Indicators
The Bollinger Bands indicator gets its name from the now famous market technician John Bollinger and it is a trend indicator. This means it is applied to a chart and traders use it to ride a trend as well as to spot reversal patterns. As a matter of fact, this indicator is being formed out of three different lines that resemble a channel and these lines are being called the Upper Bollinger Band (UBB), Middle Bollinger Band (MBB) and Lower Bollinger Band (LBB). All lines are equally important when taking a trading decision based on this indicator, but the MBB has a special meaning. Depending on the broker and trading platform one uses, the MBB can be either a simple moving average (SMA) or an exponential moving average (EMA). If you refer to the moving averages article here on the Forex Trading Academy, you’ll see that on the moving averages strategy to find out support and resistance levels it is recommended to use simple moving averages. However, when using the Bollinger Band indicator, it is recommended to use an exponential moving average (EMA) for the MBB. The reason for that comes from the fact that EMA’s are adapting in time to new price levels and thus the MBB becomes a proactive line rather than a reactive one. The image below shows you how to plot the Bollinger Band indicator on a chart on the MetaTrader 4 trading platform. As usual with any trend indicator, by clicking Insert/Indicators/Trend, and then choosing the Bollinger Band, a popup window will appear on the screen.
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The pop-up window, as it can be seen below, allows one to edit the indicator, choosing the variable for the MBB as well as the color and size of the three lines to be plotted. It is recommended that the MBB have the 20 periods selected and the average to be applied at the closing prices of each and every candle.
How to Trade with Bollinger Bands Indicator
When compared with the Parabolic SAR indicator we presented here at Forex Trading Academy, the Bollinger Bands indicator is actually allowing a trader to spot a new trend and to ride it. Moreover, exiting a trend can be done swiftly as well as identifying reversal patterns. How can this be done only with three lines? Very simple.
The Magic of the Middle Bollinger Band (MBB)
The MBB is the most important line of the three lines that make up the Bollinger Band indicator and in a way resembles the effect the Median Line in the Andrew’s Pitchfork is acting (more about that to come later in our project here). While on the Pitchfork all three lines are straight ones, on the Bollinger Band, due to the fact that more or less they represent moving averages of some sort, the lines are not straight.
The way to use the MBB is to wait for the price to travel on the upper side of the Bollinger Bands (between MBB and UBB) as this defines a bullish trend. Using the same logic, a bearish trend forms when the price is staying in the lower part of the Bollinger Bands indicator (between MBB and LBB). According to Elliott Waves theory, for every market action one should expect a reaction, or for every move the market makes, a correction should come. The idea is to spot that correction with the MBB so when the price is coming into the MBB line, to buy on a bullish trend and sell on a bearish one. The chart above shows clear entry levels for the long side as the price is travelling in a bullish trend. The bigger the time frame, the more powerful the entries are. Due to the fact that the MBB is an exponential moving average, it is adapting to current prices and therefore a trader knows in advance its level with each new candle that forms. This allows traders to use pending orders when wanting to enter a new trade but one thing should be considered before placing a pending order: skip it if a reversal pattern formed previously.However, the same chart shows three different reversal points. What are they and how to use them?
Spotting Reversal Patterns with Bollinger Bands Indicator
To spot a reversal pattern in a current trend or even the beginning of a new trend, UBB and LBB are being used. Traders are looking for a candle to close below the LBB (if a new bearish trend is about to form) or above the UBB (if a new bullish trend is about to form). The chart above shows three reversal points. The first one turns to be a fake move as price closes below the LBB and then retraces into the MBB. Using the logic just mentioned in the previous paragraphs, this calls for a short trade to be taken by the time the MBB is touched. This short should be closed in a loss by the time price closes above the UBB as another reversal point, this time in the direction of the previous trend, forms. However, at this point, it is not recommended to trade on the long side anymore as the fact that price was able to form a reversal bearish pattern earlier shows the upside trend is losing its strength. Needless to say that a few candles later another bearish reversal pattern appears, and this time a new trend, a bearish one forms. From this moment on, one should look to ride the newly formed trend using the method explained earlier.
The beauty of this indicator comes from the fact that the two methods described here are working on any time frame the indicator is attached to. If you are a scalper, then Bollinger Bands indicator is your friend no matter you’re applying it on the one minutes or the five-minute chart. The same principles are valid on any time frame. If you are a swing trader, and your time horizon for a trade spreads from a few hours to days and even weeks, then Bollinger Bands indicator can easily spot reversal points and levels to add to a trend. No matter the type of a trader you are or the trading style used, Bollinger Bands indicator is a valuable tool for every trader’s kit.
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