Bollinger Bands on eToro. How does it work?

eToro offers a wide variety of markets and assets for you to choose from and as many technical tools needed for your trading. Bollinger Bands is one of the most popular ones, so let’s have a look at what they are.

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What are Bollinger Bands?

Bollinger Bands is a widely employed technical analysis indicator that is used to identify overbought and oversold market conditions or identify when the price is at a point relatively higher or lower as compared to its past performance. It is created from 3 trend lines, the upper and the bottom lines that are drawn 2 (set by default) standard deviations around the 3d line, which is a moving average (a simple moving average usually) of a price of an asset. In this way, the price is bound to a certain range by the upper and lower bands, each 2 standard deviations above and below the moving average line in between. In this way the width of this range or the distance between the lines determined by volatility, which is measured by the standard deviation. The more volatile the asset is then the wider the range of the indicator.

There are 4 things that affect your Bollinger Bands indicator on eToro. Let’s have a look at each one of them.

1.First of all there is the number of standard deviations to be set for this indicator. Standard deviation is a measure of how spread prices are compared to their average and the default is 2 standard deviations. A higher coefficient makes the range of the indicator wider and chart approaches the upper and the lower limit less often.

Have a look at this example below. Here the coefficient of standard deviations is set to 2.

Here the number of standard deviations is 5; it is immediately obvious that the bands with 5 standard deviations are much wider than the indicator with only 2 standard deviations. The chart almost never crosses the bands.

2. Period is the value that determines the time period or the number of candlesticks used in the calculation of the simple moving average line in the indicator. The default is a 20 day moving average for the middle line of Bollinger Bands, which smoother over prices over the first 20 days. Choosing a greater value for the period will smoothen price of an asset over a larger time period but that doesn’t necessarily mean the indicator will provide better trading information.

3. Type of the moving average. The default is set to a simple moving average, but this however has the limitation of assigning equal weights to older and more recent prices. You can then adjust that to another type, for example an exponential, that suits your trading strategy best.

4. Field determines the price of the asset used to construct the indicator, chosen as daily closing by default, but that could be adjusted to adjusted closing, open, high or low price.

Using Bollinger Bands on eToro

Squeezes and Breakouts

Bollinger Bands are of course closely related to volatility. A period of very low volatility will make the upper and the lower bands coming closer together, ‘squeezing’ the moving average line in between. This could be interpreted as a possible signal of upcoming higher volatility and opportunities for trades. This of course also works the other way, wider bands are caused by higher volatility and may signal lower volatility in the future. These are however not a signal to open or close a trade and cannot tell you the time when a change in price may occur and into which direction.

Another aspect of Bollinger Bands you need to beware of are breakouts. Many times trader consider the price going through either the upper or lower bands to be a trading signal to open either a buy or a sell position. However, breakouts are not informative of the direction of possible price change or its extent.

Price Action

Bollinger Bands are used to determine how strong a price of an asset is increasing or decreasing and when it could be reversing. The price will be pushing up and reaching the upper band often in a strong uptrend and could signal a potential buy opportunity and the lower band in a strong downtrend, signaling a possible sell trade. A price may move back and forth in between the upper and the middle bands within a strong uptrend, but when it approaches the lower band this may be indicative of a possible reversal; a downtrend can be interpreted with the same logic, with the price moving near the lower band. A trader may also interpret the price moving closer to the upper band of the indicator as a sign that the asset is overbought and vice versa, when the price is approaching the lower band the asset can be considered to be oversold.

Limitations of Bollinger Bands

Bollinger Bands are certainly a very useful indicator to a trader, yet their main purpose is to indicate volatility of an asset. Its main drawdown comes from the fact that, being a lagging indicator based on a simple moving average, it reacts to changes in a price trend but cannot predict future price levels.  For example, when a strong trend in an upward or downward direction appears this indicator is not very useful in providing trading signals. Also, the usefulness of this indicator depends on the setting you choose and its suitability to the particular market or asset you are trading.

It could therefore be a good idea to use Bollinger Bands in combination with 2 or 3 other indicators that are more indicative of price signals, for example the Relative Strength Index (RSI) or a Moving Average Convergence Divergence (MACD). Don’t forget that trading involves capital loss gains and it is important to have a good understanding of trading basics before risking your own money. Best of luck and enjoy trading on eToro!

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