Technical indicators are essential tools that day traders use to predict price movements. These signals are based on price, volume, and things like open interest of a security. Technical indicators allow day traders to make profitable trades over short periods of time and without always having a clear view of the fundamentals that drive prices over the long run. Commonly used technical indicators are Bollinger Bands. How to use Bollinger Bands in day trading is one of the important skills that a day trader should learn.
Introduction to Bollinger Bands
Bollinger Bands are a trading tool developed about forty years ago. They consist of three lines on a chart that move along with the asset price. The center line is a simple moving average, typically a twenty day moving average. The upper and lower lines are determined by standard deviations above and below the moving average. Two standard deviations are the common distance. Sixty-eight percent of all data points (prices) fall within one standard deviation above and below the mean. Ninety-five percent of all data points fall within two standard deviations.
As an asset price goes up and down over time the Bollinger Bands show the trader how volatile the market has been over time as the bands diverge with excessive volatility and converge in less volatile markets. As the asset price moves higher within the range of the bands an asset is considered overbought and as it falls toward the lower band it is considered oversold. Both of these can be signals to place trades based on the expectation that the asset will reverse course and return to the average price.
Understanding the Bollinger Band Squeeze
Movement of asset price between the two Bollinger Bands helps a day trader see if an asset is overbought or oversold. The width of the bands tells the day trader how volatile the market is. When the two bands start to converge it tells the trader that virtually all price points are falling within an ever-closer trading range. This is called a Bollinger Band squeeze. This is a period of low volatility which may often precede significant price movement either up or down. It is important to realize that such a “squeeze” does not necessarily tell the day trader which way the market will go next. This is a good example of why astute and disciplined day traders commonly use more than one technical indicator as well as keeping an eye of fundamentals that are driving the market. This way a trader can often make better sense of a Bollinger Squeeze and better predict subsequent price direction.
Interpreting Bollinger Band Signals
A benefit of a tool like Bollinger Bands is that it lets a day trader take in market information at a glance instead of having to refer to a spreadsheet or table of data. Interpreting Bollinger Band signals may require more information than what the bands show. For example, when the asset price is heading up very close to the top band, is it going to break out of the band, revert to the mean price, or simply hover there causing the subsequent moving average and bands to slope upward? Here is one of the places where using another technical indicator like the money flow index, moving average convergence divergence, relative strength index, or stochastics can help the day trader make the most informed decision.
Bollinger Band Trading Strategies
There is a trading strategy in which both the width of Bollinger Bands and asset price direction within the bands are important. An asset price is heading up toward the upper band. This can be seen as the asset being overbought and an indicator that the asset price will revert toward the mean or middle of the price range. However, if the Bollinger Bands are converging into a squeeze this tells the day trader that a market consensus is developing at the higher price. This may indicate a steadily higher price for the asset and, effectively, a breakout from the previous price range. This can be a profitable situation for the day trader who uses discipline in selecting, entering, managing, and exiting their day trades.
Combining Bollinger Bands with Other Indicators
If there were one single perfect technical indicator all day traders would use it and not any other. The point is that there is no single perfect technical tool. Every one, Bollinger Bands included, gives the day trader useful but incomplete information. That is why successful day traders use the MACD or moving average convergence divergence tool, the RSI or relative strength index, or others to help fine tune what Bollinger Bands are showing and to execute effective, profitable trades. That is also why day traders typically have an active news feed available as they trade and keep abreast of fundamentals that drive prices for assets that they trade as well.