Bollinger Bands®: Understanding the Technical Analysis Tool

What are Bollinger Bands?

Bollinger Bands, developed by John Bollinger in the 1980s, are a pivotal tool in technical analysis for stock trading. These bands provide a volatility indicator, measuring a security’s price relative to past trades.

The concept revolves around volatility, gauged through standard deviation, which adjusts with market fluctuations.

As prices surge, the bands widen, while they contract during declines. Their dynamic nature makes them versatile across various securities.

Calculation

To understand Bollinger Bands®, it’s essential to comprehend the calculation behind them. The process begins with computing the simple moving average (SMA) of the security, typically based on a 20-day SMA.

This SMA averages the closing prices for the initial 20 days, with subsequent data points adjusting as new information arrives.

Next, we determine the standard deviation of the security price. Standard deviation, a fundamental statistical concept, measures the average variance within a dataset. By taking the square root of the variance, we derive the standard deviation.

What Do Bollinger Bands® Tell You?

Bollinger Bands® provide valuable insights into market conditions, particularly regarding volatility and potential overbought or oversold scenarios.

Traders often interpret the proximity of prices to the upper or lower bands as indications of market sentiment. When prices approach the upper band, it may suggest an overbought market, while proximity to the lower band could indicate oversold conditions.

John Bollinger, the creator of Bollinger Bands®, has outlined a set of rules to guide traders in utilizing these bands effectively.

The Squeeze

One central concept of Bollinger Bands® is the “squeeze,” occurring when the bands constrict around the moving average.

This period of low volatility is often considered a precursor to increased volatility and potential trading opportunities. Conversely, wider bands signal decreased volatility, potentially prompting traders to consider exiting positions.

Breakouts

Approximately 90% of price action occurs between the two bands of Bollinger Bands®. Breakouts, occurring when prices move beyond these bands, are significant events.

However, it’s crucial to note that breakouts themselves do not provide directional cues for future price movement. Traders should exercise caution and consider other factors in their decision-making process.

Example

Visualizing Bollinger Bands® in action can enhance understanding. In a typical chart, these bands encapsulate the 20-day SMA of a stock, illustrating price movements relative to volatility.

As market volatility increases, the bands widen, while less volatile periods lead to band contraction.

W-Bottoms and M-Tops

Bollinger Bands facilitate the identification of W-Bottoms and M-Tops, patterns indicative of potential trend reversals.

W-Bottoms form near or below the lower band, followed by a rebound towards the middle band, signaling a bullish reversal. Conversely, M-Tops occur near or above the upper band, foreshadowing a bearish reversal.

Limitations

While Bollinger Bands® offer valuable insights, they are not infallible and come with limitations. Traders should not rely solely on them as a standalone trading system but rather integrate them with other indicators for a comprehensive analysis.

John Bollinger himself recommends combining Bollinger Bands® with two or three non-correlated indicators to enhance signal accuracy.

Additionally, the use of a 20-day SMA and two standard deviations may not suit all market conditions, necessitating adjustments based on individual preferences and market dynamics.

Bollinger Bands® FAQs

Which Indicators Work Best with Bollinger Bands®?

Bollinger Bands® complement various technical indicators, with popular choices including the relative strength index (RSI) and the BandWidth indicator.

Traders often use BandWidth to identify Bollinger Squeezes, indicating periods of low volatility and potential breakout opportunities.

How Accurate Are Bollinger Bands®?

Given their construction around two standard deviations from an SMA, Bollinger Bands® offer a statistical framework where approximately 95% of price action is expected to fall within the bands. However, traders should exercise caution and not solely rely on Bollinger Bands® for trading decisions.

What Time Frame Is Best Used With Bollinger Bands®?

Bollinger Bands® typically employ a 20-day moving average, providing a balanced perspective on short to medium-term price movements.

Resources

• Bollinger Bands® – Definition, Limits, Trading (corporatefinanceinstitute.com)
• 6 Bollinger Bands® Trading Strategies + Video | TradingSim
• Bollinger Bands®: What They Are, and What They Tell Investors (investopedia.com)

Mino

I’m Mino, a forex trader with years of hands-on experience and a knack for market trends. My mission? To guide you through the complexities of forex trading and help you reach your financial aspirations. With personalized strategies and proven insights, I’ve empowered countless traders to navigate the markets confidently and achieve steady profits. Join me on the path to financial success in forex trading!