Bollinger band squeeze is a function of volatility contraction, if we can express the volatility in terms of bandwidth than bollinger band squeeze would be in place if bandwidth drops to the six months low.
In this article, we will learn about bollinger band squeeze, how to calculate it using a tool, and how to trade with it.
Table of Contents
- Bollinger Band Formula
- What is Bollinger Band Squeeze
- Bollinger Bandwidth For Band Squeeze
- Trading Bollinger Band Squeeze
- Key Takeaways
- Frequently Asked Questions
Bollinger band is a useful tool that quickly reacts to large moves in market, they provide us with an important information of whether current prices are high or low with respect to normal trading range.
Bollinger draws support and resistance lines two standard deviations above and below a 20-day simple moving average, respectively.
Bollinger Band Formula
| Upper Band | Middle band + 2 standard deviations |
| Middle Band | 20 Period Moving Average |
| Lower Band | Middle band – 2 standard deviations |
standard deviation σ = √ ∑ (xi -µ)2 / N
σ = population standard deviation
N = the size of the population
xi = each value from the population
µ = the population mean
Many traders might use different periods moving average as suitable to their timeframe, in such cases it is important to adjust the multiplier of Standard Deviations to better adopt the volatility considerations –
| Periods | Multiplier |
|---|---|
| 10 | 1.9 |
| 20 | 2 |
| 50 | 2.1 |
What is Bollinger Band Squeeze
Bollinger band squeeze is thought to form when volatility decreases to the point where it starts to serve as a forecasting indicator for future price movements. Like prices moves in cycles volatility also undergoes periods of expansion and contractions.
When closely examined, these periods can show us trends and instances of range-bound movement.
“Bollinger bands are driven by the volatility and squeeze is a pure reflection of volatility.”
John .A Bollinger
When the trading range narrows, consolidation starts, the moving average is flat, and the bollinger bands get closer to the price structure, we can observe the squeeze in action.
Other factors like volume and the market cycle are crucial in determining the future course of action; once these factors come into alignment, one can anticipate an explosive move in the direction of the previous major trend.
Bollinger Bandwidth For Band Squeeze
Bandwidth allows traders to gauge band squeeze. To calculate bandwidth, subtract the lower band from the upper band and then normalize by dividing the middle band.
BandWidth = (Upper BB-Lower BB)/Middle BB
Bandwidth, along with trading ranges, marks the beginning of directional trends. When bandwidth is narrow, price breakouts from this range often give rise to long periods of trending market moves.
Bandwidth is also helpful to mark the end of trends, stronger trends results in expansion of volatility which causes upper band to move along the side of price action and lower band moves opposite, bandwidth in such cases flattens out or turns down to reverse the effect of bollinger band and this marks the end of an trend.
Trading Bollinger Band Squeeze
The first step is to identify the squeeze using the bandwidth described in the previous section; a simple rule to find the ideal bandwidth is to take 6 months of low bandwidth to justify a bollinger band squeeze; ideally, during a squeeze, price action is range bound, low volatility, and narrow.
Once the squeeze has been identified, another concept to grasp is the fake breakout before prices eventually surge towards the volatility expansion.
Fake breakouts are a common occurrence during or after a squeeze; one method of trading a squeeze is to wait and let price action lead the way; the second method is to enter the position early with a small size and then add to the original position once the breakout is confirmed in the direction of the prior trend.
Option traders use the bollinger band squeeze reverse methodology; once the band expands and the lower band turns down in an uptrend and the upper band turns up in a downtrend, there is a very good chance of a reversal and option premiums are very high, and option sellers may take the position by selling these highly priced call or put options.
Key Takeaways
- Low volatility period is followed by high volatility periods
- Bollinger Bandwidth indicator is used to calculate the bollinger band squeeze
- Bollinger bands were first used in 1983.
- Key to bollinger bands is volatility
- Default setting of bollinger band is 20 period MA and 2 standard deviations
- Bandwidth can also be used to predict starting and end of trends.
- Bollinger Band Trading strategy is a popular price action trading method which is used by option, futures and stock market traders.
Frequently Asked Questions
What is Bollinger Band Squeeze?
Bollinger Band Squeeze is a volatility contraction phenomenon that leads to volatility expansion, and it is a useful method for selecting momentum trades using the Bollinger Band.
How to use Bollinger Band Squeeze?
One way to use Bollinger band squeeze is to wait for a valid breakout and trade in direction of the breakout.
Is Bollinger Band Squeeze profitable?
Both momentum and option traders can profit from the Bollinger band squeeze. However, fake breakouts should be avoided as they harm the effectiveness of this strategy.
Author
