Use Bollinger Bands to measure trends

Bollinger Bands® is a type of chart indicator for technical analysis and is widely used by traders in many markets, including stocks, futures and currencies. Created by John Bollinger in the 1980s, the groups provide unique insights into price and volatility. In fact, there are a number of uses for Bollinger Bands®, such as determining overbought and oversold levels, as a trend-following tool, and for monitoring for breakouts.

Calculation of Bollinger Bands

Bollinger Bands® are composed of three lines. One of the more common calculations uses a 20-day simple moving average (SMA) for the middle band. The upper band is calculated by taking the middle band and adding twice the daily standard deviation to that amount. The lower band is calculated by taking the middle band minus twice the daily standard deviation.

The Bollinger Band® formula consists of the following:



BOLU = MA(TP, n) + m ∗ σ

[

TP

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n

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BOLD = MA ( TP , n ) − m ∗ σ

[

TP

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n

]

where: BOLU = Upper Bollinger Band BOLD = Lower Bollinger Band MA = Moving average TP (typical price) = ( High + Low + Close ) ÷ 3 n = Number of days in smoothing period m = Number of standard deviations σ

[

TP

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n

]

= Standard deviation over last n periods of TP \begin{aligned} &\text{BOLU} = \text {MA} ( \text {TP}, n ) + m * \sigma [ \text {TP}, n ] \\ &\text{BOLD} = \text {MA} ( \text {TP}, n ) – m * \sigma [ \text {TP}, n ] \\ &\textbf{where:} \\ &\text {BOLU} = \text {Upper Bollinger Band} \\ &\text {BOLD} = \text {Lower Bollinger Band} \\ &\text {MA} = \text {Moving average} \\ &\text {TP (typical price)} = ( \text{High} + \text{Low} + \text{Close} ) \div 3 \\ &n = \text {Number of days in smoothing period} \\ &m = \text {Number of standard deviations} \\ &\sigma [ \text {TP}, n ] = \text {Standard deviation over last } n \text{ periods of TP} \\ \end{aligned}

,DIVIDE=MOM(TP,a)+m∗p[TP,n]BOLD=MOM(TP,a)−m∗p[TP,n]where:DIVIDE=Upper Bollinger BandBOLD=Lower Bollinger BandMOM=Moving averageTP (typical price)=(High+Low+Near)÷3a=Number of days in smoothing periodm=Number of standard deviationsp[TP,n]=Standard deviation over last a periods of TP,

Overbought and oversold strategy

A common approach when using Bollinger Bands® is to identify overbought or oversold market conditions. When the price of the asset breaks below the lower band of the Bollinger Bands®, prices may have fallen too much and this is due to bounce. On the other hand, when price breaks above the upper band, the market may be overbought and due for a pullback.

The use of the bands as overbought / oversold indicators is based on the concept of mean reversion of the price. Mean reversion assumes that, if the price deviates significantly from the average or mean, it eventually returns to the average price.

In range-bound markets, mean reversion strategies can work well as prices bounce between the two bands. However, Bollinger Bands® do not always give accurate buy and sell signals. For example, during a strong trend, the trader runs the risk of placing trades on the wrong side of the move because the indicator may flash overbought or oversold signals too soon.

To help correct this, a trader can look at the overall direction of price and then only take trade signals that align the trader with the trend. For example, if the trend is down, only take short positions when the upper band is marked. The lower band can still be used as an exit if desired, but a new long position is not opened as this would mean going against the trend.

Create multiple bands for greater insight

As John Bollinger recognized, “markers of the bands are just that, markers, not signals.” A tick (or touch) of the upper Bollinger Band® is not by itself a sell signal. A lower Bollinger Band® indicator is not a buy signal by itself. Price can and often does “walk the talk.” In those markets, traders constantly trying to “sell the top” or “buy the bottom” are faced with a grueling series of stop-outs, or even worse, ever-increasing losses as price moves further and further away from the original entry.

At its core, Bollinger Bands® measure deviation, which is why the indicator can be very useful in diagnosing trends. By generating two sets of Bollinger Bands®, one set using the “one standard deviation” parameter and the other using the typical “two standard deviation” setting, we can look at price in a whole new way. We will call these Bollinger Band® “bands”.

In the chart below, for example, we see that when price is holding between the upper Bollinger Bands® +1 SD and +2 SD away from average, the trend is up; therefore we can define that channel as the “buying zone.” Conversely, if price channels are within Bollinger Bands® –1 SD and –2 SD, it is in the “sell zone.” Finally, if the price meanders between +1 SD band and –1 SD band, it is essentially in a neutral state, and we can say that it is in an unknown territory.

Bollinger Bands® dynamically adjust to price expansion and contraction as volatility increases and decreases. Therefore, the bands naturally widen and narrow in accordance with price action, creating a very accurate trending envelope.

A Tool for Trend Traders and Faders

Having established the basic rules for Bollinger Band® “bands”, we can now demonstrate how this technical tool can be used by both trend traders who seek to exploit momentum and fade traders who like to take advantage of trend exhaustion or reversals. Returning to the chart above, we can see how trend traders will position long once price has entered the “buy zone”. They will then be able to stay in the trade as the Bollinger Band® “bands” encapsulate most of the price action from the move higher.

As for an exit point, the answer is different for each individual trader, but one reasonable possibility would be to close a long trade if the candle on the candlestick charts turns red and more than 75% of its body is below the “buy zone.” Using the 75% rule, price clearly falls out of trend at that point, but why insist that the candle is red? The reason for the second condition is to prevent the trend trader from being “wiggled” out of a trend by a quick move to the downside that bounces back into the “buy zone” at the end of the trading period.

Notice how, in the following chart, the trader is able to stick with the move for most of the uptrend, exiting only when the price starts to consolidate at the top of the new range.

Bollinger Band® “bands” can also be a valuable tool for traders who like to exploit trend exhaustion by helping to identify the turn in price. Note, however, that trading against trends requires much larger margins of error, as trends will often make several attempts at continuation before reversing.

In the chart below we see that a fade trader using Bollinger Band® “bands” will be able to quickly diagnose the first hint of trend weakness. After prices fall out of the trend channel, the fader can decide to make classic use of Bollinger Bands® by shorting the next tick from the upper Bollinger Band®.

As for the stop loss points, the stop just above the swing high will practically guarantee that the trader is stopped out, as the price will often make many breakouts at the recent top as buyers try to extend the trend. Instead, it is sometimes wise to measure the width of the “no man’s land” area (distance between +1 and –1 SD) and add it to the upper band. By using the volatility of the market to help determine a stop loss level, the trader avoids stopping out and can remain in the short trade once the price begins to decline.

Bollinger Bands Squeeze Strategy

Another strategy to use with Bollinger Bands® is called a squeeze strategy. A pinch occurs when the price moves aggressively and then begins to move sideways in a tight consolidation.

A trader can visually identify when the price of an asset is consolidating because the upper and lower bands are getting closer together. This means the volatility of the asset has decreased. After a period of consolidation, the price often makes a larger move in either direction, ideally on high volume. The expansion of volume on a breakout is a sign that traders are betting with their money that the price will continue to move in the direction of the breakout.

When the price breaks through the upper or lower band, the trader buys or sells the asset, respectively. A stop loss order is traditionally placed outside the consolidation on the opposite side of the breakout.

Bollinger vs. Keltner

Bollinger Bands® and Keltner Channels are different but similar indicators. Here’s a quick look at the differences, so you can decide which one you like better.

Bollinger Bands® use standard deviation of the underlying asset, while Keltner Channels use the average true range (ATR), which is a measure of volatility based on the volume of trading in the security. Apart from how the bands / channels are created, the interpretation of these indicators is generally the same.

Since Keltner channels use mean true range rather than standard deviation, it is common to see more buy and sell signals generated in Keltner channels than when using Bollinger Bands®.

The Bottom Line

There are several uses for Bollinger Bands®, including using them for overbought and oversold trading signals. Traders can also add multiple bands, which help highlight the strength of price movements. Another way to use the bands is to watch for volatility contractions. These contractions are typically followed by significant price breakouts, ideally on large volume. Bollinger Bands® should not be confused with Keltner Channels. Although the two indicators are similar, they are not exactly the same.