Let us learn about Bollinger bands and see how you can use the indicator to strategize. Technical analysis tools are designed based on the theory that stock markets and their charts tend to show similar patterns before a trend or a momentum change. In simple words, analysts believe that if a stock goes ‘A-B-C’ before bouncing back from a negative trend twice or thrice, you could expect a bounce back the next time the stock goes ‘A-B-C’. Of course, stock markets are much more complex than that, but often, it is our best bet.
Talking about patterns, analysts also believe that stock prices tend to hang around certain levels of support and resistance most of the time, and whenever the same is broken, there can be a trend change. Bollinger bands are a technical indicator that is used to gauge these levels to see how the current price is performing compared to the averages and strategies accordingly.
What are bollinger bands?
Bolling bands are an indicator that displays upper and lower price levels of a particular stock at any given point in time. The bands, represented by three lines, usually also doubles as a support and resistance level for the price. In other words, the price tends to stay between the upper and lower limits and when there is a breach, there could be a trend change.
The technical analysis tool developed by the famous author and financial expert John Bollinger in the 198s is still widely used. The bands were created as means to observe dynamic volatility. Volatility was believed to be static at that point in time, and Bollinger and the band had played a part in proving it wrong.
Bollinger Bands are envelopes plotted at a standard deviation level above and below a simple moving average of the price. Because the distance of the bands is based on standard deviation, they adjust to volatility swings in the underlying price.
Bollinger bands consist of three lines- the period line and the upper and lower bands. The period plots a 20-day moving average line.
To understand the two lines in the Bollinger bands, you have to understand standard deviation too. In the case of Bollinger bands, it is a variable that measures the upper and lower price levels within which the stock price moves normally.
Here, the Bollinger bands use a period and two standard deviations. By default, the value of the period of the middle line is 20, and the two other bands are two deviations away on either side.
The indicator helps to understand whether the current price of a stock can be considered high or low based on relativity. Hence, the three lines – both upper and lower bands and the period line (20 moving averages), are used together to form the indicator.
How to calculate bollinger bands?
As you can see in the above picture, Bollinger bands come with three lines and are calculated as explained above. Let us see how the same is formed using the official formula.
The upper band is the resistance level line. The same can be calculated using the below formula.
Upper Bollinger band = Moving average (typical price, number of days)+ number of standard deviations ∗σ[typical price, number of days]
By default, the number of days is 20, and the standard deviation is 2. Hence, the equation can be simplified to
Upper Bollinger band = Moving average (typical price, 20)+ 2 ∗σ[typical price, 20]
As said above, the middle band is a 20-day simple moving average. SMA is calculated using the below equation –
SMA= (A1+A2+…+An)/ n
where: An=the price of an asset at a period and the number of total periods
The lower band is found by subtracting two standard deviations from the middle band. Hence the formula is
Lower Bollinger band = Moving average (typical price, number of days) – number of standard deviations ∗σ[typical price, number of days]
After applying the defaults, the equation can be simplified into
Lower Bollinger band = Moving average (typical price, 20) – 2 ∗σ[typical price, 20]
How to interpret bollinger bands?
As we have discussed above, there are three lines to look at here – the middle band and upper and lower bands. The movement, behaviours, and distance between the lines are used to interpret the bands.
The most basic reading considers the upper band as a resistance line and the lower bank as a support line. Take a look at the graph below.
Here, you can see that the price goes down as soon as the price breaches the upper band. (area marked by the crosshair). After confirming by using indicators, you could create a suitable bearish strategy here.
The above is the opposite scenario. Here, you can see (in the marked area) that the price tends to go up after hitting the below band.
The distance between the lines is also crucial. Narrowing lines means that there is less volatility, and the current trend could reverse. Similarly, the bands expand when there is higher volatility, also showing a possible trend reversal.
Bollinger bands trading strategies
Since the Bollinger bands indicator provides traders with valuable information regarding price movements, it can be used to form trading strategies as well. Let us see some of the trading strategy examples.
Day trading uptrends
Bollinger Bands is widely used to gauge the strength of an ongoing trend and to identify when the price will start to reverse. If a particular uptrend is strong enough, you could see that the price will continuously reach or breach the upper band. The price could go slightly down upon touching the upper band, but it will continue to peck the upper band till the trend continues. Below is a chart showing a similar scenario.
Normally, in such situations, the price could hit the upper band and bounce to touch the middle band. If a price stays between the upper and middle band, it shows a strong uptrend. But if the price breaches the middle line to touch the bottom line link in the above example, it shows the chance for a trend reversal, even if the price manages to bounce back to previous levels.
Day trading downtrends
Bollinger Bands are also used to measure the strength of a downtrend and the change for a price reversal. When the bearish trend is strong, the price will continue to hang around between the middle and the lower band, touching the support line. The below picture is helpful in understanding how the same will look in a graph.
Similar to the case in the graph, the price setting its high below the middle band and low near the lower band shows a strong downtrend. But if the lows are getting higher and the price continuously fails to touch the bottom line, a trend reversal may be possible. Similarly, the price reaching or breaching the upper band indicates a slowing down of the downtrend.
You could make use of the downtrend or trade in preparation for an uptrend if you are able to gauge the strength of the trend accurately.
W-bottoms happen when the price chart makes a W pattern like in the above picture. This usually indicates a breakout in the positive direction.
The pattern is identified when the second price low is lower than the first low, but it is marked above the lower band. It occurs when a reaction low is marked closer to the bottom band.
M-top can be called the opposite of the W-bottom pattern. Here, the same is formed when a high is marked above the upper band. The price would then would go back now, but when it comes back, it will create a new high but will fail to breach the upper band if the price drops below the prior low point from here, an M-Top band. From that point, the price tends to go down rapidly.
Bollinger bands squeeze
John Bollinger has created another indicator based on Bollinger bands to calculate the width between the bands. The indicator is called Bollinger band width, and the formulate for the same is –
(Upper Bollinger band’s value – Lower Bollinger band’s value) / Middle Bollinger band value (simple moving average)
When the width between bands is low, especially on historical levels, there is always a chance for the price trend to reverse. Lower band width usually means low volatility, and hence, a volatility breakout is usually the trigger for the movement.
The above is a pictorial representation of such a breakdown. Here you can see the bands tightening and the price and volatility breaking out after a certain point.
Here, you can use other indicators to find the point of entry and exit and the direction of the trend.
Trading within the bands
As we have discussed above, the lower and upper bands act as support and resistance lines, respectively. This means the price tends to stay within the bands. This gives you a chance to use the same to formulate a minimal risk strategy.
As seen in the picture above, you sell when the price touches the upper band and buy when the price touches the lower band. Here, too, it is a wise idea to confirm the trend with a second indicator to be on the safer side.
Bollinger bands strengths
Bollinger bands are one of the easiest indicators to read. There is no complex data, and interpretations are straightforward. This makes Bollinger bands a favourite among beginners as well.
Another advantage of Bollinger bands is that it doubles as both a momentum indicator and a volatility indicator. They ensure a decent amount of accuracy as well.
They are also flexible in a way that you can use Bollinger bands over any security with decent accuracy.
Bollinger bands limitations
The biggest drawback of Bollinger bands is that they cannot be used as a standalone system to gauge trading signals. It is designed just to show the traders the current price volatility trends and resistance and support trends. Hence, it is highly advisable to use the same with two or more other indicators for best results. Even the founder of Bollinger bands officially suggests the same. People usually use indicators like moving average convergence divergence (MACD) and relative strength index (RSI) to formulate stronger strategies.
Another disadvantage while using Bollinger bands is that it gives equal importance to old and new price data. By default, moving average values of 20 days are taken to calculate the middle Bollinger band. Here, the first day’s and the 20th day’s price data will have the same weightage. A recent price movement has become diluted due to this.
Bollinger bands and Keltner
Keltner is an indicator that is commonly used, similar to Bollinger bands. But they are different in the way they work and could often give you different signals on occasions.
The biggest difference between them is that the Keltner channel uses ATR while Bollinger bands use standard deviations to form the bands. Hence, most of the differences are based on the difference in characters of ATR and standard deviation.
ATR is more sensitive towards short-term ups and downs, while Bollinger bands give you a cleaner graph.
As a trader, the choice between a slow-reacting indicator and a fast-reacting indicator is based on your trading strategy.
Like with strategies formed with any other trading indicator, the best ones often have elements of fundamental research and are backed up by another indicator. Hence, make sure you club your Bollinger bands strategies with other elements to get the best out of the indicator.
Can Bollinger bands be used as a standalone indicator for trading signals?
Bollinger bands vary to provide you with useful momentum and volatility information. But that information is not always enough to form trading strategies on, especially in finding entry and exit points. Hence, it is a wise idea to use another indicator to help with entry and exit points.
What are the best Bollinger Bands trading strategies?
We have mentioned above some of the best strategies can could work with Bollinger bands. But trading within the bands is a low-risk, independent strategy that could be the most popular.
How to form the best Bollinger bands trading strategies?
The best way to form strategies using Bollinger bands is by understanding the information Bollinger bands are able to give you and using it wisely to form a strategy with other indicators as well.