Bollinger Bands

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Bollinger Band® Definition

What Is a Bollinger Band®?

A Bollinger Band® is a technical analysis tool defined by a set of lines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of the security’s price, but can be adjusted to user preferences. Bollinger Bands® were developed and copyrighted by famous technical trader John Bollinger,

In the chart depicted 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.

Key Takeaways

  • Bollinger Bands® are a technical analysis tool developed by John Bollinger.
  • There are three lines that compose Bollinger Bands: A simple moving average (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, but can be modified.

Understanding Bollinger Bands

How To Calculate Bollinger Bands®

The first step in calculating Bollinger Bands® is to compute the simple moving average of the security in question, typically using a 20-day SMA. A 20-day moving average would average out the closing prices for the first 20 days as the first data point. The next data point would drop the earliest price, add the price on day 21 and take the average, and so on. Next, the standard deviation of the security’s price will be obtained. Standard deviation is 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 spread out 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 the mean. 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:

What Do Bollinger Bands® Tell You?

Bollinger Bands® are a highly popular technique. 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. However, these conditions are not trading signals. The bands give no indication when the change may take place or which direction price could move.

Breakouts

Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event. The breakout is not a trading signal. The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.

Limitations of Bollinger Bands®

Bollinger Bands® are not a standalone trading system. They are simply 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. He believes it is crucial to use 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 they are computed from a simple moving average, they weight 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.

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The bottom line is that Bollinger Bands® are designed to discover opportunities that give investors a higher probability of success.

How to Use Bollinger Bands

Congratulations on making it to the 5th grade! Each time you make it to the next grade you continue to add more and more tools to your trader’s toolbox.

“What’s a trader’s toolbox?” you ask.

Let’s compare trading to building a house.

Just like in trading, some trading tools and indicators are best used in particular environments or situations. So, the more tools you have, the better you can adapt to the ever-changing market environment.

Or if you want to focus on a few specific trading environments or tools, that’s cool too. It’s good to have a specialist when installing your electricity or plumbing in a house, just like it’s cool to be a Bollinger Band or Moving Average specialist.

There are a million different ways to grab some pips!

You might not necessarily use all of these tools, but it’s always nice to have plenty of options, right?

You might even find one that you understand and comfortable enough to master on its own. Now, enough about tools already!

Let’s get started!

Bollinger Bands

Bollinger Bands, a chart indicator developed by John Bollinger, are used to measure a market’s volatility.

Basically, this little tool tells us whether the market is quiet or whether the market is LOUD!

When the market is quiet, the bands contract and when the market is LOUD, the bands expand.

Notice on the chart below that when price is quiet, the bands are close together. When price moves up, the bands spread apart.

That’s all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger Band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn’t feel like typing it all out.

In all honesty, you don’t need to know any of that junk. We think it’s more important that we show you some ways you can apply the Bollinger Bands to your trading.

Note: If you really want to learn about the calculations of a Bollinger Band, check out John’s book, Bollinger on Bollinger Bands.

The Bollinger Bounce

One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the “Bollinger Bounce.”

By looking at the chart below, can you tell us where the price might go next?

If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.

What you just saw was a classic Bollinger Bounce. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels.

Many traders have developed systems that thrive on these bounces and this strategy is best used when the market is ranging and there is no clear trend.

Now let’s look at a way to use Bollinger Bands when the market is TRENDING…

Bollinger Squeeze

The “Bollinger Squeeze” is pretty self-explanatory. When the bands squeeze together, it usually means that a breakout is getting ready to happen.

If the candles start to break out above the TOP band, then the move will usually continue to go UP.

If the candles start to break out below the BOTTOM band, then price will usually continue to go DOWN.

Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?

If you said up, you are correct again!

This is how a typical Bollinger Squeeze works.

This strategy is designed for you to catch a move as early as possible.

Setups like these don’t occur every day, but you can probably spot them a few times a week if you are looking at a 15-minute chart.

There are many other things you can do with Bollinger Bands, but these are the two most common strategies associated with them.

It’s time to put this in your trader’s toolbox before we move on to the next indicator.

Day Trading With Bollinger Bands

Bollinger Bands are a technical indicator developed by John Bollinger. The indicator forms a channel around the price movements of an asset. The channels are based on standard deviations and a moving average. Bollinger bands can help you establish a trend’s direction, spot potential reversals and monitor volatility. All of this can help you make better trading decisions if you follow a few simple guidelines.

Bollinger Band Basics

Bollinger bands have three lines, an upper, middle and lower. The middle line is a moving average of prices; the parameters of the moving average are chosen by the trader. There is no magic moving average number, so the trader can set the moving average so it aligns with the techniques discussed below.

The upper and lower bands are drawn on either side of the moving average. The distance between the upper and lower band is determined by standard deviations. The trader determines how many standard deviations they want the indicator set at, although many use two standard deviations from the average.

No magic number exists here either. Choose a setting that aligns with the techniques below, for the asset being traded. The attached chart shows a one-minute crude oil futures chart with Bollinger Bands. Trendlines have been drawn to show the trend direction based on Bollinger Band guidelines discussed below.

Day Trading Uptrends with Bollinger Bands

Bollinger bands help assess how strongly an asset is rising (uptrend), and when the asset is potentially losing strength or reversing. This information can then be used to help make trading decisions. Here are three guidelines for using Bollinger Bands in an uptrend.

  • When the price is in a strong uptrend it will typically touch or run along the upper band during impulse waves higher. When it fails to do that it shows the uptrend may be losing momentum.
  • Even during an uptrend prices drop for periods of time, known as pullbacks. During an uptrend, if the price is moving strongly then pullback lows will typically occur near or above the moving average (middle) line. The pullback doesn’t have to stall out near the middle line, but it does show strength if it does.
  • When the price is in a strong uptrend it shouldn’t touch the lower band. If it does that’s a warning sign of a reversal.

Read the „Issues“ section below for occasions when Bollinger Bands tend not to provide reliable information.

Day Trading Downtrends with Bollinger Bands

Bollinger bands help assess how strongly an asset is falling (downtrend), and when the asset is potentially strengthening (to the upside) or reversing. This information can then be used to help make trading decisions. These three guidelines, similar to uptrend guidelines, can help use Bollinger Bands in a downtrend.

  • When the price is in a strong downtrend it will typically touch or run along the lower band during impulse waves lower. When it fails to do that it shows the downtrend may be losing momentum.
  • Even during a downtrend, prices may rally for periods of time, called pullbacks. During a downtrend, if the price is moving strongly lower then pullback highs will typically occur near or below the moving average (middle) line. The pullback doesn’t have to stall out near the middle line, but it does show selling strength if it does.
  • When the price is in a strong downtrend it shouldn’t touch the upper band. If it does that’s a warning sign of a reversal.

Check the „Issues“ section below for occasions when Bollinger Bands tend not to provide reliable information.

Spotting Trend Reversals with Bollinger Bands

Using the trend guidelines, here are the summary guidelines for spotting reversals.

  • If the price is in an uptrend, and continually hitting the upper band (and not the lower band), when the price hits the lower band it could signal that a reversal has commenced. If the price rallies again, it likely won’t be able to reach the upper band or the recent price high.
  • If the price is in a downtrend and continually hitting the lower band (and not the upper band), when the price hits the upper band it could signal that a reversal has commenced. If the price declines again, it likely won’t be able to reach the lower band or the recent price low.

Issues With Bollinger Bands

The first issue with Bollinger Bands is their limitation as just one indicator. John Bollinger recommends using them with two or three other un-correlated indicators, instead of seeing them as a stand-alone trading system.

With established guidelines on how to use the Bollinger Bands, find settings for the indicator that allow you to apply the guidelines to a particular asset you are day trading. Alter the settings so that when you look at historical charts you can see how the Bollinger Bands would have helped you.

If the Bollinger Bands don’t help you then change the settings or don’t use the bands to trade that particular asset. Ideal Bollinger Bands setting vary from market to market, and may even need to be altered over time even when trading the same instrument.

Once the indicator is set up and seemingly working well, the indicator may still have a tendency to produce false signals. During low volatility times, the bands will contract, especially if the price is moving sideways. During such times the price may bounce off both the upper and lower band. In this case, it isn’t necessarily a reversal signal, though. The narrow bands are just closer to the price and thus likely to be touched.

Bollinger Bands aren’t a perfect indicator; they are a tool. They don’t produce reliable information all the time, and it’s up to the trader to apply band settings that work most of the time for the asset being traded.

Final Word

The Bollinger Bands indicator is just a tool. It has flaws, and won’t produce reliable signals all the time. It can help you stay on the right side of trend and spot potential reversals, though. For that, you’ll need to set up the indicators so they align with the guidelines discussed above. Random or default setting on the indicator may not work well. Adjust the indicator and test it out with paper trades before using the indicator for live trades.

The guidelines above are not a trading strategy on their own. A trading strategy requires entry points, exit points, and risk management, which weren’t discussed in this article. Bollinger Bands can be combined with a trading strategy, though, such as the day trading stocks in two hours method.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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