Bollinger Bands

1. Overview of Bollinger Bands

Bollinger Bands are a technical indicator developed in the 1980s by John Bollinger, used to visualize price volatility and identify overbought/oversold conditions and potential reversal points in the market. Bollinger Bands are displayed on a chart as two bands placed above and below a central moving average (typically the 20-day SMA).

2. Components of Bollinger Bands

Bollinger Bands are composed of the following three elements:

• Moving Average (Middle Band)
  • Formula: Simple Moving Average (SMA) over a given period. Typically, a 20-day SMA is used.
  • Serves as an indicator of the central price movement.
• Upper Band
  • Formula: Moving Average + (2 × Standard Deviation).
  • Indicates upward market pressure or overbought conditions.
• Lower Band
  • Formula: Moving Average - (2 × Standard Deviation).
  • Indicates downward market pressure or oversold conditions.

3. How to Use Bollinger Bands

3-1. Band Contraction and Expansion

• Bollinger Bands widen (expand) when price volatility is high and contract when volatility is low. This contracted state is called a "squeeze."
• Band contraction (squeeze) suggests a state where market energy is accumulating and indicates a high probability that the price will start a significant move (expansion) thereafter. Conversely, band expansion can sometimes indicate a temporary convergence of price movement and a sign of reversal.

3-2. Band Break

• Upper Band Breakout: When the price breaks above the upper band, it may indicate that a bullish market is continuing. This can be a buy signal for trend-following strategies. However, it can also indicate overbought conditions, so it is important to judge in conjunction with other indicators.
• Lower Band Breakout: When the price breaks below the lower band, it may indicate that a bearish market is continuing or show signs of reversal as an oversold signal. This can be interpreted as a sell signal for trend-following strategies or a buy signal for counter-trend strategies.

3-3. Counter-Trend Signals

The ±2σ lines of the Bollinger Bands are considered to be a range where prices statistically fall with a high probability (approximately 95%). Therefore, some traders see a price move outside the bands as a sign of reversal and employ a counter-trend strategy. Specifically, if the price exceeds the upper band, they consider selling, judging it as "overbought." If the price falls below the lower band, they consider buying, judging it as "oversold." However, caution is required with counter-trend strategies because "band walks" occur when a strong trend develops, causing the price to continue moving along the bands.

3-4. Combining Bollinger Bands and RSI

By combining Bollinger Bands with oscillator indicators such as the Relative Strength Index (RSI), more accurate analysis can be expected. For example,

• If the price touches or breaks the upper band of the Bollinger Bands and the RSI is in the overbought zone of 70% or higher, it is a counter-trend sell signal suggesting a potential pullback.
• If the price touches or breaks the lower band of the Bollinger Bands and the RSI is in the oversold zone of 30% or lower, it is a counter-trend buy signal suggesting a potential rebound.

By combining them in this way, it becomes easier to avoid false signals compared to making judgments based on a single indicator.

4. Practical Examples

Specific entry strategies that can be considered include the following.

• Buy Signal: If the price approaches or touches the lower band and oscillators like RSI suggest oversold conditions (e.g., RSI below 30), consider a buy entry after confirming a candlestick reversal pattern (e.g., bullish engulfing, hammer with lower wick). A stop loss can be placed slightly below the recent low, and the middle band or upper band can be targets for taking profit.
• Sell Signal: If the price approaches or touches the upper band and oscillators like RSI suggest overbought conditions (e.g., RSI above 70), consider a sell entry after confirming a candlestick reversal pattern (e.g., bearish engulfing, shooting star with upper wick). A stop loss can be placed slightly above the recent high, and the middle band or lower band can be targets for taking profit.

5. Considerations and Limitations

• False Signals (Whipsaws): Bollinger Bands are effective tools for indicating the occurrence or reversal of trends, but counter-trend signals are not always accurate. When the market has a strong trend (especially when fundamental factors are involved), a "band walk" can occur where the price continues to move along the bands after breaking through, potentially causing counter-trend trades to fail.
• Market Environment Dependence: Since Bollinger Bands are calculated based on price volatility, in ranging markets with extremely low volatility, the band width becomes very narrow, and there is a tendency for more false signals to occur. In such market environments, it is necessary to prioritize other indicators and analysis methods.
• Importance of Parameter Settings: Generally, a period of 20 and standard deviation of ±2σ are used, but the optimal parameters vary depending on the financial instrument being traded, time frame, and market characteristics. Verification with historical data (backtesting) and adjustment are recommended.

6. Summary

Bollinger Bands are a very powerful technical tool that helps to visually capture market volatility and identify overbought/oversold conditions and trend reversal points. They can be used for counter-trend strategies by utilizing the price breaking through the bands as a sign of reversal, or to understand the strength of the trend and market energy accumulation from the band contraction (squeeze) and expansion. The middle band also serves as an important baseline indicating the direction of the trend.

However, Bollinger Bands are not foolproof, and caution is required especially during "band walks" when a strong trend occurs, and against false signals in ranging markets. Therefore, instead of using them alone, combining them with other technical indicators like RSI and MACD, candlestick pattern analysis, and fundamental analysis enables more accurate trading decisions.

Thus, by correctly understanding Bollinger Bands and utilizing them while recognizing their characteristics and limitations, they can become a powerful tool for predicting price fluctuations and trend movements and a useful aid in supporting traders' decision-making in FX and CFD trading.