Look at price trends plus volatility.
Source: StockCharts.com. Notes by Encyclopædia Britannica, Inc.
Bollinger Bands is a popular technical analysis tool used by stock market traders to gauge price volatility and identify potential buy or sell signals. Developed in the early 1980s by John Bollinger, a well-known trader and Chartered Market Technician (CMT), Bollinger Bands provide insight into market conditions by combining the concepts of a moving average and a volatility measure into one indicator.
According to Bollinger, its namesake is not only for stocks, but can also be used for futures, commodities and currency trading. Additionally, Bollinger Bands are timeframe agnostic, meaning they apply to all timeframe charts.
The mechanics of Bollinger Bands
Bollinger Bands combine a simple moving average (SMA) and a measure of price volatility via standard deviations (SD). The calculation of Bollinger Bands involves three main components:
Simple moving average. The SMA is calculated by summing a certain number of closing prices and dividing the result by the chosen period. For example, a 20-day SMA adds up the closing prices of the past 20 trading days and divides the total by 20. Standard deviation. The standard deviation measures how spread out prices are from the mean. It quantifies the volatility of the price range. The standard deviation is usually calculated with the same time period as the SMA. Upper and lower bands. Bollinger Bands are typically constructed by adding and subtracting a certain number of standard deviations (usually two) from the SMA. This creates an upper band and a lower band that encloses the price range, forming a channel that expands and contracts as volatility increases and decreases.
Here is the formula for calculating Bollinger Bands (at two standard deviations) based on a 20-day simple moving average:
Upper band = 20-day SMA + (20-day SD x 2) Middle band = 20-day SMA Lower band = 20-day SMA – (20-day SD x 2)
Compare Bollinger Bands with other indicators
Some technical indicators attempt to measure volatility, such as Average True Range (ATR), standard deviations or the CBOE Volatility Index (VIX). Others are designed to identify trends, such as moving averages, Parabolic SAR and Average Directional Index (ADX).
Bollinger Bands are unique in that they contain both a moving average and standard deviations. By combining these two elements, Bollinger Bands capture both the trend (through the moving average) and volatility (through the standard deviations). This makes them particularly useful for identifying periods of high or low volatility and potential price reversals.
Because Bollinger Bands is a particularly visual technical indicator, those dynamic changes in volatility are easy to see on a price chart, especially at the extremes. Some traders incorporate these visual cues into their strategies by analyzing band width – as well as where price is in relation to the bands – and then combining this analysis with other indicators.
Use Bollinger Bands in a trading strategy
Bollinger Bands can help traders identify overbought and oversold conditions based on the concept of mean reversion, which suggests that an asset tends to converge on its mean or average price over time.
When the price is trading near the upper band, it indicates that a stock is overbought and may be due for a price correction. When the price is near the lower band, it indicates that the stock is oversold and may be ripe for a recovery.
This can provide a strategy for range-bound markets, with the trader going long when price touches the lower band and short when it touches the upper band. However, when a stock is moving in a strong trend, these signals may not work as well. Trend prices can continue to “walk” along the upper or lower bands for a long time.
One way traders can adapt a Bollinger Bands strategy in a trending market is by identifying the direction of the trend and then taking only corresponding trades. For example, if the trend is up, a trader will buy when price touches the lower band, but will not short when price touches the upper band. Instead, they can use the next touch of the (rising) lower band to add to their position.
The bottom line
Bollinger Bands can be a powerful technical tool for stock market traders. By combining a moving average with a measure of price volatility, Bollinger Bands provide insights into potential price swings, overbought or oversold conditions and market volatility.
Remember that no single indicator can guarantee successful trading outcomes. Traders should always exercise caution and conduct thorough analysis before making investment decisions.
This article is intended for educational purposes only and not as an endorsement of a specific financial strategy. Encyclopædia Britannica, Inc., does not provide legal, tax or investment advice.
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