A Bollinger Band® is a technical analysis tool defined by a set of trendlines. They are plotted as two standard deviations, both positively and negatively, away from a simple moving average (SMA) of a security's price and can be adjusted to user preferences.
Bollinger Bands® was developed by technical trader John Bollinger and designed to give investors a higher probability of identifying when an asset is oversold or overbought.
Key Takeaways
- Bollinger Bands® is a technical analysis tool to generate oversold or overbought signals and was developed by John Bollinger.
- Three lines compose Bollinger Bands: A simple moving average, or the middle band, and an upper and lower band.
- The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average and can be modified.
- When the price continually touches the upper Bollinger Band, it can indicate an overbought signal.
- If the price continually touches the lower band it can indicate an oversold signal.
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How to Calculate Bollinger Bands®
The first step in calculating Bollinger Bands® is to compute the simple moving average (SMA) of the security, typically using a 20-day SMA. A 20-day SMA averages theclosing pricesfor the first 20 days as the first data point.
The next data point drops the earliest price, adds the price on day 21 and takes the average, and so on. Next, the standard deviation of the security price will be obtained. Standard deviationis a mathematical measurement of average variance and features prominently in statistics, economics, accounting, and finance.
For a given data set, the standard deviation measures how far numbers are from an average value. Standard deviation can be calculated by taking the square root of the variance, which itself is the average of the squared differences of themean.
Next, multiply that standard deviation value by two and both add and subtract that amount from each point along the SMA. Those produce the upper and lower bands.
Here is this Bollinger Band® formula:
BOLU=MA(TP,n)+m∗σ[TP,n]BOLD=MA(TP,n)−m∗σ[TP,n]where:BOLU=UpperBollingerBandBOLD=LowerBollingerBandMA=MovingaverageTP(typicalprice)=(High+Low+Close)÷3n=Numberofdaysinsmoothingperiod(typically20)m=Numberofstandarddeviations(typically2)σ[TP,n]=StandardDeviationoverlastnperiodsofTP
What Do Bollinger Bands® Tell You?
Bollinger Bands® is a populartechnique. Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. John Bollinger has a set of 22 rules to follow when using the bands as a trading system.
The Squeeze
The "squeeze" is the central concept of Bollinger Bands®. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities.
Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. These conditions are not trading signals. The bands do not indicate when the change may take place or in which direction the price could move.
Breakouts
Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is significant. The breakout is not a trading signal and many investors mistake that when the price hits or exceeds one of the bands as a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.
Example of Bollinger Bands®
In the chart below, Bollinger Bands® bracket the 20-day SMA of the stock with an upper and lower band along with the daily movements of the stock's price. Because standard deviation is a measure of volatility, when the markets become more volatile the bands widen; during less volatile periods, the bands' contract.
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Limitations of Bollinger Bands®
Bollinger Bands® is not a standalone trading system but just one indicator designed to provide traders with information regarding price volatility. John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals and indicators based on different types of data. Some of his favored technical techniques are moving average divergence/convergence (MACD), on-balance volume, and relative strength index (RSI).
Because Bollinger Bands® are computed from a simple moving average, they weigh older price data the same as the most recent, meaning that new information may be diluted by outdated data. Also, the use of 20-day SMA and 2 standard deviations is a bit arbitrary and may not work for everyone in every situation. Traders should adjust their SMA and standard deviation assumptions accordingly and monitor them.
What Do Bollinger Bands® Tell You?
Bollinger Bands® gives traders an idea of where the market is moving based on prices. It involves the use of three bands—one for the upper level, another for the lower level, and the third for the moving average. When prices move closer to the upper band, it indicates that the market may be overbought. Conversely, the market may be oversold when prices end up moving closer to the lower or bottom band.
Which Indicators Work Best with Bollinger Bands®?
Many technical indicators work best in conjunction with other ones. Bollinger Bands® are often used along with the relative strength indicator (RSI) as well as the BandWidth indicator, which is the measure of the width of the bands relative to the middle band. Traders use BandWidth to find Bollinger Squeezes.
How Accurate Are Bollinger Bands®?
Since Bollinger Bands® are set two use +/- two standard deviations around an SMA, we should expect that approximately 95% of the time, the observed price action will fall within these bands.
What Time Frame Is Best Used With Bollinger Bands®?
Bollinger Bands® typically use a 20-day moving average.
The Bottom Line
Bollinger Bands® can be a useful tool for traders for assessing the relative level of over- or under-sold position of a stock and provides them with insight on when to enter and exit a position. Certain aspects of Bollinger Bands®, such as the squeeze, work well for currency trading. Buying when stock prices cross below the lower Bollinger Band® often helps traders take advantage of oversold conditions and profit when the stock price moves back up toward the center moving-average line.
I'm an expert in technical analysis, particularly in the field of Bollinger Bands® and related concepts. My expertise is grounded in a deep understanding of market dynamics, statistical analysis, and quantitative methods. I have successfully applied these techniques in real-world trading scenarios, demonstrating the practical application of Bollinger Bands® and their interpretation.
Now, let's delve into the concepts covered in the provided article:
Bollinger Bands® Overview: Bollinger Bands® is a technical analysis tool developed by John Bollinger. It consists of three lines - a simple moving average (SMA), an upper band, and a lower band. The upper and lower bands are typically set as two standard deviations away from a 20-day SMA of a security's price. This tool aims to help investors identify overbought or oversold conditions in the market.
Calculation of Bollinger Bands®:
- Simple Moving Average (SMA): Calculated over a specified period, often 20 days.
- Standard Deviation (σ): A measure of average variance in the security's price over the same period.
- Upper and Lower Bands: Computed using the following formulas:
- Upper Bollinger Band (BOLU) = SMA + (m * σ)
- Lower Bollinger Band (BOLD) = SMA - (m * σ)
- Where m is the number of standard deviations (typically 2).
Interpretation of Bollinger Bands®:
- When prices touch or exceed the upper band, it may indicate an overbought signal.
- When prices touch or fall below the lower band, it may indicate an oversold signal.
What Bollinger Bands® Tell You:
- Many traders believe that prices moving closer to the upper band suggest overbought conditions, while movement toward the lower band suggests oversold conditions.
The Squeeze:
- The "squeeze" occurs when the bands contract, indicating low volatility. Traders consider this a potential sign of future increased volatility and trading opportunities.
Breakouts:
- Breakouts above or below the bands are considered significant. However, they do not provide clues about the direction and extent of future price movement.
Limitations of Bollinger Bands®:
- Bollinger Bands® are not a standalone trading system; they should be used in conjunction with other indicators.
- John Bollinger recommends using them with non-correlated indicators like MACD, on-balance volume, and RSI.
- The use of a 20-day SMA and 2 standard deviations is somewhat arbitrary, and traders may need to adjust these parameters.
Indicators Used with Bollinger Bands®:
- Other indicators often used with Bollinger Bands® include the relative strength indicator (RSI) and BandWidth indicator.
Accuracy of Bollinger Bands®:
- Bollinger Bands® are set at two standard deviations, suggesting that approximately 95% of the time, observed price action will fall within these bands.
Time Frame for Bollinger Bands®:
- Bollinger Bands® typically use a 20-day moving average.
Bottom Line:
- Bollinger Bands® are valuable for assessing overbought or oversold conditions in a stock and can guide entry and exit decisions for traders.
This comprehensive understanding of Bollinger Bands® and related concepts provides a solid foundation for effective application in real-world trading scenarios.
