Bollinger Bands : A Powerful Indicator in Stock Trading
A Bollinger Band is a tool used in technical analysis that consists of lines representing price levels. These lines are drawn based on a security’s average price and its standard deviations. They were created by John Bollinger, a technical trader, to help investors determine if an asset is overbought or oversold with a higher chance of accuracy.
- John Bollinger created the Bollinger Bands, a technical analysis technique for generating oversold or overbought indications.
- Bollinger Bands are made up of three lines: an upper, a lower, and a simple moving average, which serves as the middle band.
- It is possible to change the upper and lower bands, which are normally +/- 2 standard deviations from a 20-day simple moving average.
- When the price repeatedly approaches the upper Bollinger Band, it may be a warning that the market is overbought.
- Price touching the bottom band repeatedly may be an oversold signal.
How to Calculate Bollinger Bands
Computing the security’s simple moving average (SMA), often using a 20-day SMA, is the first step in computing Bollinger Bands®. The initial data point for a 20-day SMA is the average of the closing prices for the first 20 days.
The following data point subtracts the price from the first data point, adds the price from day 21 and calculates the average, and so on. The security price’s standard deviation will then be ascertained. In statistics, economics, accounting, and finance, standard deviation is a statistical measurement of average variance.
The standard deviation calculates the deviation of a group of numbers from an average value. The variance, which is the average of the squared differences of the mean, can be used to compute standard deviation by taking the square root of the variance.
Then, double that value of the standard deviation by two and add and deduct that sum from each point along the SMA. The upper and lower bands are created by those.
Here is this Bollinger Band formula:
BOLU=Upper Bollinger Band
BOLD=Lower Bollinger Band
TP (typical price)=(High+Low+Close)÷3
n=Number of days in smoothing period (typically 20)
m=Number of standard deviations (typically 2)
σ[TP,n]=Standard Deviation over last n periods of TP
What Do Bollinger Bands Tell You?
Popular method is Bollinger Bands. Many traders hold the view that the market is more overbought or oversold the closer prices move to the upper band or the lower band, respectively. When employing the bands as a trading strategy, John Bollinger provides a list of 22 rules to adhere to.
The fundamental idea behind Bollinger Bands® is the “squeeze”. A squeeze occurs when the bands compress the moving average as they draw closer to one another. Traders view a squeeze as a potential sign of future rising volatility and trading opportunities. A squeeze denotes a period of low volatility.
In contrast, the likelihood of a drop in volatility and the likelihood of leaving a trade increase as the bands move farther apart. These circumstances are not buy or sell indications. The bands do not predict when the change would occur or which way the price might go.
90% of price movement takes place between the two bands. Any breakout between the bands or above them is important. Many investors confuse the breakout, which is not a trading signal, for a buy or sell signal when the price touches or crosses one of the bands. Breakouts don’t reveal anything about the scope and direction of upcoming price movement.
Example of Bollinger Bands
The stock’s 20-day SMA and daily price fluctuations are shown in the chart below with Bollinger Bands® encircling them with an upper and lower band, respectively. Because standard deviation is a measure of volatility, the bands broaden during periods of increased volatility and contract during periods of decreased volatility.
Limitations of Bollinger Bands
Bollinger Bands is merely one indicator used to warn traders about price volatility; it is not a stand-alone trading method. They should be used in conjunction with two or three other non-correlated indicators, according to John Bollinger, that offer more immediate market alerts and indicators based on other sources of data. Moving average divergence/convergence (MACD), on-balance volume, and relative strength index (RSI) are a few of his preferred technical indicators.
Bollinger Bands are calculated using a simple moving average, which gives older price data the same weight as more recent data. As a result, fresh information may be masked by stale information. Additionally, the choice of the 20-day SMA and two standard deviations is somewhat discretionary and might not be appropriate in all circumstances. Traders should monitor and alter their standard deviation and SMA assumptions as necessary.
What Do Bollinger Bands Tell You?
Traders can determine the direction of the market’s movement based on pricing using Bollinger Bands. Three bands are used: one for the moving average, one for the lower level, and one for the upper level. Prices moving towards the upper band suggest that the market can be overbought when they do so. When prices end up going more towards the lower or bottom band, however, the market can be oversold.
Which Indicators Work Best with Bollinger Bands?
A lot of technical indicators perform best when used in combination with others. The relative strength indicator (RSI) and the BandWidth indicator, which calculates the width of the bands in relation to the central band, are frequently used in conjunction with Bollinger Bands. Bollinger Squeezes are identified by traders using BandWidth.
How Accurate Are Bollinger Bands?
Since Bollinger Bands are designed to employ +/- two standard deviations around a SMA, we may anticipate that the observed price action will fall within these bands roughly 95% of the time.
What Time Frame Is Best Used With Bollinger Bands?
Bollinger Bands typically use a 20-day moving average.
The Bottom Line
The Bollinger Bands can be a helpful tool for traders to determine how overbought or undersold a stock is relative to other stocks and gives them guidance on when to enter and exit a position. The squeeze feature of Bollinger Bands® is effective for currency trading. Trading stocks when they cross below the lower Bollinger Band® can often help investors profit from oversold conditions when the stock price rises back towards the middle moving-average line.
Bollinger Band Trading Strategies
Trend Reversal Strategy: Bollinger Band Breakout
Traders look for price breakouts beyond the upper or lower bands as potential signals for trend reversals. When the price breaks above the upper band, it suggests a bullish reversal, while a breakout below the lower band indicates a bearish reversal.
Range-Bound Strategy: Bollinger Band Bounce
In a range-bound market, where prices fluctuate between support and resistance levels, traders can use Bollinger Bands to identify potential buying and selling opportunities. When the price touches the lower band, it may indicate an oversold condition and a potential bounce back towards the middle band. Similarly, a touch of the upper band may signal an overbought condition and a potential pullback towards the middle band.
Volatility Strategy: Bollinger Band Width
Traders can utilize Bollinger Band Width, which measures the distance between the upper and lower bands, to gauge market volatility. A narrowing Band Width suggests low volatility, while an expanding Band Width indicates high volatility. Traders may consider initiating trades when volatility is low and anticipate price movements when volatility increases.
Read More: Technical Analysis of The Financial Markets
FAQs – Bollinger Bands Indicator
1. What are Bollinger Bands?
Bollinger Bands are a technical analysis tool consisting of three lines plotted on a price chart: the middle band, upper band, and lower band. The middle band represents the average price, while the upper and lower bands represent potential resistance and support levels, respectively.
2. How are Bollinger Bands constructed?
The middle band is typically a simple moving average (SMA), while the upper and lower bands are derived from the standard deviation of price movements. The bands expand and contract based on market volatility.
3. What is the purpose of Bollinger Bands?
Bollinger Bands help traders identify potential price volatility, trend reversals, and overbought or oversold conditions. They assist in determining potential entry and exit points in trading.
4. How can Bollinger Bands be used to identify trend reversals?
When the price breaks above the upper band, it may signal a bullish reversal, while a breakout below the lower band could indicate a bearish reversal. Traders monitor these breakouts as potential trading opportunities.
5. Can Bollinger Bands be used in range-bound markets?
Yes, Bollinger Bands are useful in range-bound markets. Traders can identify potential buying opportunities when the price touches the lower band (indicating oversold conditions) and potential selling opportunities when the price touches the upper band (indicating overbought conditions).
6. What is the Bollinger Band Squeeze?
The Bollinger Band Squeeze occurs when the bands contract due to decreased market volatility. Traders see this as a potential precursor to significant price movements and adjust their strategies accordingly.
7. How can Bollinger Band Width be used?
Bollinger Band Width measures the distance between the upper and lower bands. Traders use it to gauge market volatility. A narrowing Band Width suggests low volatility, while an expanding Band Width indicates high volatility. Traders may consider initiating trades during periods of low volatility and anticipate price movements during high volatility.
8. Are Bollinger Bands effective on all timeframes?
Bollinger Bands can be applied to various timeframes, from short-term intraday charts to long-term charts. However, the effectiveness may vary based on the timeframe and the specific characteristics of the security being analyzed.
9. Should Bollinger Bands be used alone or in conjunction with other indicators?
It is recommended to use Bollinger Bands in conjunction with other technical indicators and fundamental analysis for a comprehensive trading approach. Bollinger Bands provide valuable insights, but combining them with other tools can enhance decision-making and confirm trading signals.
10. Are Bollinger Bands suitable for all types of securities?
Bollinger Bands can be applied to various securities, including stocks, currencies, commodities, and indices. However, it is essential to consider the specific characteristics and trading dynamics of each security when using Bollinger Bands for analysis and decision-making.
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