What are Bollinger Bands?

It contains upper and lower bands, creating a price channel around the price movement line and capturing the fluctuations. Evaluating the price channel contributes to developing trading signals. It is widely applied for analyzing price movements of various financial instruments like stocks and currencies. However, it is also used in fields other than financial markets. For instance, it is used in the defect detection of patterned fabric.

Key Takeaways

  • Bollinger Bands (BB) refers to a technical analysis tool focusing on security price and volatility to disclose overbought and oversold points. It is formulated by John Bollinger of Bollinger Capital Management in the 1980s.The main three components are the middle, upper, and lower bands. The upper and lower bands are based on standard deviations, and an N Day Moving Average forms the middle band.The bands come closer during low volatility and widen during high volatility.

Bollinger Bands Explained

The Bollinger Band design contains three main components, the middle band, upper band, and lower band. The middle band is based on a simple moving average line, and the upper and lower bands present the standard deviations.

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The most common time frame for moving average is 20 days for short-term analysis and 200 days for long-term analysis.

  • The middle band: An N day moving averageThe upper band: K times above the standard deviation of the middle band

      Generally, the k value is equal to 2

  • The lower band: K times below the standard deviation of the middle band

      Generally, the k value is equal to 2)

Standard deviation is a measure of volatility. Its integration in the technique makes it fast in reacting to the large moves and throws insight into what is happening in the market. In addition, the combination of standard deviation and moving average makes it logically consistent because moving average is used to calculate the standard deviation, and both use the same data as input.

Bollinger Bands Trading Indicators

The band tightens during low volatility and widens during high volatility. The price of a security moving above the upper band points to the overbought scenario, and the price moving below the lower band indicates an oversold scenario.

Traders can design their Bollinger Bands trading strategies based on the bands’ movement. For example, When the price crosses the lower band from below and starts rising, a buy signal emerges; traders can buy and exit when the price breaks the MA line, and if the price crosses the upper band from above, a sell signal appears.

Formula & Calculation

Upper band = MA(TP, n) + m ∗ σ [TP , n]

Lower band = MA(TP, n) − m ∗ σ [TP, n]

Here,

  • MA:  Moving averageσ[TP, n]: Standard deviation over the last n periods of TPTP (typical price): (High+Low+Close)/3n: Number of days in smoothing periodm: Number of standard deviations

Calculation Example

In a 5-bar Bollinger Band based on the last five closes, the moving average is 25.50. Therefore, the standard deviation value derived using the moving average, the last five closes are 0.5, and the number of standard deviations is 2.

  • MA(TP, n): 25.50σ [TP , n]: 0.5n: 5m: 2

= 25.5 + 2*0.5

=26.5

=25.5 – 2*0.5

=24.5

How to Use? (Squeeze and Breakout)

A squeeze occurs when the two bands tighten in space, that is, a decrease in the width of the band, making it narrow. It is an indicator of low volatility in the market. On the other hand, it also indicates that a period of high volatility is approaching. Hence a significant oscillation is always expected after a squeeze; it can be a price break above the upper band or a price break below the lower band that is an uptrend or downtrend is expected, and it is considered one of the best times to execute a trade.

Identifying securities or stocks with narrowing bands and low bandwidth levels is important. For example, one can locate security with bandwidth having its minimum value in six months. The traders can prepare for a volatility expansion even if the technique doesn’t indicate price movement direction. Traders also use other technical indicators in conjunction to confirm the trends.

When the price level closes above the upper band, it is a positive volatility breakout. And likewise, a downside close below the lower Bollinger Band gives a negative volatility breakout. The traders will deduce a potential buy signal if the price breaks above the upper band and a potential sell signal if the price breaks below the lower band.

This is a Guide to what are Bollinger Bands. We explain trading strategies involving BBs, bandwidth indicators, and how to use this strategy. You can learn more from the following articles –

BBs are based on moving averages and standard deviations. Hence, the model quickly reacts to the changes in input data and large moves. However, it is not predictive of trend direction, and its sole focus on price and volatility and avoiding other relevant information makes it a risky strategy. Hence it is appropriate to use in combination with other technical analysis indicators.

It is a technical indicator that focuses on the difference between the upper and the lower Bollinger Bands. It is calculated by dividing the difference between the upper and lower bands by the middle bands. When the BBs expand, the bandwidth increases and decreases when the BBs contract or direct towards each other.

It helps in constructing trading strategies by determining oversold and overbought stocks etc. In addition, traders can select the entry and exit points by evaluating the price channel created by the bands capturing the price fluctuations. Furthermore, it is also combined with other indicators to ascertain the information derived.

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