Limitations of Bollinger Bands and How To Avoid False Signals

Trading with technical indicators can be challenging, especially if it is your first time using it. While indicators like Bollinger Bands can provide helpful insight, they also have limitations that can lead to false signals if you don't understand how to use them properly.

This article will discuss the drawbacks of relying solely on Bollinger Bands and strategies to avoid whipsaws.

Brief Overview of Bollinger Bands

Developed in the 1980s by renowned technician John Bollinger, Bollinger Bands are a type of technical indicator that plots bands around the price of a security. The bands consist of three lines:

• An SMA (simple moving average) in the middle
• An upper band that is a standard deviation above the SMA
• A lower band that is a standard deviation below the SMA

Bollinger Bands can identify overbought and oversold levels and provide insights into price targets. When the price reaches the upper or lower band, there is potential for a reversal.

The bands also contain price - about 90% of price action should fall between the two bands.

6 Drawbacks of Bollinger Bands

While useful, Bollinger Bands have six main drawbacks you should be aware of:

1. Too Late Reversal Signals

One of the primary uses of Bollinger Bands is to identify potential reversals when the price hits or tags the outer bands. However, the problem is these reversal signals often come too late.

By the time the price reaches the upper band, the uptrend is usually already overextended and due for a pullback. Similarly, when the price tags are in the lower band, the downtrend typically experiences significant downside momentum and selling pressure.

Acting on the band tag reversal signal can mean entering a reversal after much of the move has already occurred.

2. Whipsaws in Sideways or Rangebound Markets

Bollinger Bands are prone to generating whipsaws when the market trades sideways or in a rangebound state. During periods of low volatility when prices are consolidating, the bands squeeze together and narrow.

The alternating prices between tagging the upper and lower bands can generate repeated overbought and oversold signals.

This whipsaw price action can cause traders to get faked out, forcing them to exit positions prematurely or generating stopouts. It creates frustration in rangebound periods.

3. Lack of Continuation Signals

A drawback of Bollinger Bands is that they provide no insight into when a trend might continue after a pullback. The bands help signal potential reversals when tagged but don't indicate whether the trend will resume after a brief retracement or consolidation.

Traders are left with guesswork as to whether a pullback is just temporary within an ongoing trend or the prelude to a more significant reversal. This ambiguity can lead to missed opportunities if it delays entry into strong continuation moves.

4. Subjective Interpretation of Band Width

Based on volatility, the bands' width requires subjective interpretation by the trader. Wider bands indicate higher volatility and narrow bands suggest lower volatility. However, what constitutes wide or narrow is a matter of perspective.

Traders may interpret bandwidth differently, leading to varied trading decisions. This can undermine the predictive value of bandwidth as an indicator.

5. Lagging Indicator

Like all moving averages, Bollinger Bands are lagging indicators. The bands are based on past price action and volatility and, therefore, lags current market conditions. This makes Bollinger Bands more useful for confirming trends rather than predicting reversals early.

6. No Directionality

Bollinger Bands do not indicate the overall trend direction. They only identify overbought or oversold levels, not whether prices are trending up or down. This limits their usefulness as a standalone indicator for determining trend direction.

Learn more by checking out this useful article: How to Use a Supertrend Indicator for Trading

Tips for Using Bollinger Bands Effectively

While the drawbacks above are undoubtedly valid, Bollinger Bands can still be used effectively in your trading.

Use With Other Indicators

Bollinger Bands work best when combined with other indicators. Using them alone is a mistake - they should be just one piece of your analysis, not the sole indicator.

Some indicators that complement Bollinger Bands include:

• Moving averages - confirm the direction of the trend
• Momentum oscillators - identify overbought/oversold levels
• Volume - look for surges in buying/selling pressure

With confirmation from other indicators, Bollinger Bands signals become much more reliable setups.

Take a look at this article: Moving Averages (MA) - A Comprehensive Guide

Focus on Expansion and Contraction

Rather than just relying on tag signals, pay attention to band expansion and contraction.

Expanding bands highlight increased volatility and potential trend changes. Tightening bands signal waning momentum and likely rangebound conditions ahead.

Factor band expansion/contraction into your trading decisions. Times of expansion warrant extra caution - the trend is becoming over-extended.

Periods of contraction indicate range trading - stay patient and await a clear breakout.

Use Band Tag Sparingly

Only act on band tag signals in overbought/oversold conditions confirmed by other indicators. For example:

• Price tags upper Bollinger Band
• RSI is at 70+ (overbought territory)
• Volume climaxed (potential exhaustion signal)

With multiple signs of an overextended uptrend, a touch of the upper band carries more weight as a reversal signal. Use these high-probability setups.

Avoid acting on low-probability band tags that lack supporting evidence from other indicators. This helps decrease whipsaws.

Check this informative article: Tips When Using A Moving Average Formula

In conclusion,

While Bollinger Bands have some limitations, they can still be a useful technical analysis tool when used correctly.

Traders should not rely solely on band tag signals but incorporate bands as part of a broader strategy with confirmation from other indicators.

Focus on the band's width trends and combine bands with tools like moving averages and oscillators. Use high-probability band tag signals sparingly.

Overall, practice using Bollinger Bands and explore how they complement other indicators. With experience, traders can harness Bollinger Bands effectively to better time entries and exits.

Become a member of markets.com and access a cutting-edge trading platform!
“When considering “CFDs” for trading and price predictions, remember that trading CFDs involves a significant risk and could result in capital loss. Past performance is not indicative of any future results. This information is provided for informative purposes only and should not be considered investment advice.”