Using Bollinger Bands to Gauge Market Trends and Volatility The US Thanksgiving holiday usually marks a quieter period for trading, as US financial markets are closed on Thursday and US traders often take the Friday off as a holiday to benefit from a long weekend. This can see both lower volume and volatility, so we thought we’d take this time to outline one of our favourite technical indicators, called Bollinger Bands.
The aim is to increase your knowledge of a new indicator you may consider worth knowing, ahead of the first week of December, which is packed full of important events that may kick start markets moving again into the end of 2024.
We intend to highlight how Bollinger Bands can potentially be applied to help read both current trending and volatility conditions for any asset.
To help with this, we are using the US 500 index as an example to outline the type of band set-ups you can consider using within your day-to-day analysis and trading.
What are Bollinger Bands?
Bollinger bands are made of 3 lines – the mid-average, upper and lower band (see chart above).
The mid-average is a 20 period moving average, with the upper and lower bands calculated using 2 standard deviations either side of the mid-average.
If you are unsure of the concept or how to calculate 2 standard deviations, please don’t worry, the Pepperstone charting system will do this automatically for you and add them to the chart of any asset you may wish to analyse.
The mid-average is used to reflect the direction of the on-going trending condition of a market. If its rising, an uptrend is in place, while if it’s falling, a downtrend is evident.
How the bands act in relation to the mid-average is key when using Bollinger bands. They can often offer important confirmation of the trend and can show if acceleration phases in the price of a particular asset may be seen within that trend.
The most important thing to know about Bollinger bands is that they react to increasing volatility within price. Periods of increasing volatility see both bands widening away from the mid-average, while if volatility is decreasing, they contract or draw closer to the mid-average.
Let’s look at this further.
What Set-Ups are We Looking For and What Do They Mean?
There are 5 set-ups to be aware of when using Bollinger bands and each offer clues to the next activity in the price of a particular asset.
1st: Volatility Increasing Within a Confirmed Trend:
When the mid-average is either rising (to highlight an uptrend) or falling (to reflect a downtrend), and the bands are widening to show increasing volatility within that trend, alongside the upper band being touched in an uptrend, or within a downtrend, the lower band being touched.
When all the above conditions are evident, the potential is for that move to extend further than perhaps anticipated.
On the US 500 Index chart above, the green arrows mark when these more aggressive trending conditions are in place.
2nd: Volatility Decreasing Within a Confirmed Trend:
Where the mid-average is either rising (uptrend) or falling (downtrend), and the bands are contracting reflecting decreasing volatility within that trend.
When these set-ups are in place, the speed of the recent directional move is slowing, and the possibilities are increasing for a consolidation in price.
During this period, we may want to consider reducing or closing positions and reverting to the side lines, as a setback could materialise, as a reaction to the latest move.
On the chart above, red arrows mark these consolidation periods.
3rd: Mid-Average Support/Resistance Holds Within Corrective Moves:
Within these corrective or recovery phases after periods of increasing volatility and widening bands, we must watch how the mid-average support or resistance is defended.
If the mid-average is rising, highlighting an uptrend and holding price weakness, it may resume the direction of the original trend. Similarly, when the mid-average is falling, highlighting a downtrend and holding price strength, it may continue in the same direction. However, past trends and technical indicators are not reliable predictors of future performance, and market conditions can change unexpectedly.
On the new chart above, these points are marked by the blue vertical arrows.
4th: Trend Channels Form Between Mid-Average and Upper/Lower Band:
When the rising mid-average holds as suggested in the third set-up above, this can see uptrend or downtrend channels form in price.
In an uptrend, the rising mid-average holds price weakness and turns it higher.
While this still sees price strength, volatility doesn’t increase but remains steady, reflected by rising parallel bands and support continues to be found by the rising mid-average.
However, resistance materialises following tests of the upper band, for a setback towards the support of the still rising mid-average.
This pattern ends if the price of the asset breaks below the support offered by the rising mid-average.
On the latest chart above, this is marked by the purple arrows.
When the declining mid-average holds price strength, as suggested in the 3rd set-up above, this can see a downtrend channel form in price.
In a downtrend, the declining mid-average holds price strength and turns it back lower.
While this scenario still sees price weakness, volatility remains steady and doesn’t increase, reflected by the declining bands being parallel, and resistance continues to be found by the falling mid-average.
However, tests of the lower band see support materialise and a rally in price ensues towards resistance marked by the still falling mid-average.
This pattern ends if the price of the asset breaks above resistance offered by the falling mid-average.
This situation is the opposite of the chart above.
5th: Mid-Average Broken to See More Extended Rally/Sell-Off:
Mid-average support or resistance gives way, but while price weakness or strength develops, the direction of the average doesn’t change.
This sees a limited move in the direction of the mid-average break.
During price weakness, if the mid-average continues to rise, the lower band can act as a support level and prompt a rally.
During price strength, if the mid-average continues to fall, the upper band acts as a resistance level from which price weakness can emerge again.
These signals are marked by the green rectangles in the chart above.
It is important to note in this example, if an upper or lower bands is touched and then both bands start to widen alongside the mid-average changing direction, then this is highlighting the 1st set up described above, meaning we are observing increasing volatility within what is a new trending condition.
In this situation, we may need to consider adjusting our trading strategy to reflect this new directional shift in price.
Conclusion:
While past signals within Bollinger Bands are not a guarantee of future signals, by utilising the set-ups described above, they may offer an indication of the latest trending conditions in the price of a particular asset.
More importantly, they help to highlight when increasing volatility is materialising and when more sustained price moves are possibly on the cards, in the direction of the on-going trend.
Also, they show when decreasing volatility can result in a period of consolidation and a reaction to the recent move due.
Take a look at the Pepperstone charting system and consider whether Bollinger Bands may help you establish the next directional moves for the asset you’re trading.
The material provided here has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Whilst it is not subject to any prohibition on dealing ahead of the dissemination of investment research we will not seek to take any advantage before providing it to our clients.
Pepperstone doesn’t represent that the material provided here is accurate, current or complete, and therefore shouldn’t be relied upon as such. The information, whether from a third party or not, isn’t to be considered as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product or instrument; or to participate in any particular trading strategy. It does not take into account readers’ financial situation or investment objectives. We advise any readers of this content to seek their own advice. Without the approval of Pepperstone, reproduction or redistribution of this information isn’t permitted.
