Day traders use Bollinger Bands® as a technical indicator to display a chart reading of volatility by how tight they are around a financial instrument. The degree of tightening or widening them surrounding the price action of a financial instrument determines the level of volatility. Chart facing, a 21-day moving average (preferred period of time) is surrounded by an upper and lower Bollinger Band®. They are meant to serve as a technical indicator of overbought (wide bands) and oversold (tight bands) market conditions.
How Are Bollinger Bands® Read?
Looking at financial instrument charting software with ‘tight’ Bollinger Bands® applied to the price action, a significant move to the up or down side may occur soon. However, if a financial instrument chart has ‘wide’ bands applied to price action, this may signal a significant move is not likely to occur in the not too distant future. Tight and wide, they can also be used as a counter technical indicator of both potential low and high volatility in that present price action is used to predict a different, future market move.
With the above said, the best conditions for the indicator’s use are periods of low volatility with scant price fluctuation. The more time passed in a low volatility environment, the more they will tighten around a financial instrument’s price action. When tightening more than usual, the bands may be signaling an increase in future volatility.
How Can Bollinger Bands® Be Used?
When analyzing Bollinger Bands® with the intention of day trading online, do not rush to make a decision if price action breaches the top or bottom band, as this is not always an indication of an immediate market move. That said, though most price action movement occurs within the indicator, a breach of an outer band is a rare occurrence indeed, but cannot be relied on to be a guaranteed buy/sell signal. In addition, though widely used, Bollinger Bands® are actually meant to be used in tandem with two or more other technical indicators such as Relative Strength Index (RSI) and MACD.
It is important to note, before day trading based on a signal derived from Bollinger Bands® and two other indicators, backtesting historical market trends with all of these indicators is strongly suggested. Backtesting these indicators against the historical market trend you are focusing on will provide an idea of how your strategy would have performed in historical market conditions.
Brian Horowitz writes Forex and futures trading articles at featuring examples of how technical indicators can potentially be used to trade financial markets.