Summary - Bollinger bands are a popular technical analysis tool used by traders as a way to gauge a security’s price moves and to measure volatility. Interpreting the information revealed by the Bollinger bands helps investors determine whether a particular security may be overbought or oversold. The use of Bollinger bands as part of a trading strategy gives investors signals that can help them determine when to enter and exit specific positions based on price action.
Bollinger bands are formed above and below a center line which represents an exponential moving average. One of the most commonly used EMAs is the 20-day moving average. The default setting for the Bollinger bands is one standard deviation above and one standard deviation below this center line. Both the number of periods in the moving average and the standard deviation can be adjusted in most trading software programs.
Bollinger bands give off trading signals that can help investors interpret overbought or oversold conditions. However, Bollinger bands are reactive more than they are predictive and traders should use other volatility indicators to get a sense of the trend strength associated with the price action they are seeing.
Trading based on technical analysis requires an understanding of price action and market volatility. When you understand both the trend (i.e. the direction) a stock is going and how much volume is trading (i.e. the volatility). A common way to understand this is by plotting price movements versus technical indicators such as moving indicators and Bollinger bands.
This article will define what Bollinger bands are, how to create one on a stock chart, technical terms you should know to better understand Bollinger bands, how to use Bollinger bands in trading, and limitations of Bollinger bands.
What are Bollinger bands?
Bollinger bands are a technical analysis tool that clarifies the price action of a security by showing its volatility through the expansion or contraction of the bands over a period of time. A Bollinger band is made up of a series of lines that are plotted at a specific standard deviation above and below a simple moving average (SMA) for the security being tracked. Bollinger bands were the creation of the famous technical trader, John Bollinger.
When the bands expand (i.e. show divergence) it indicates higher volatility meaning the stock price is subject to larger movements in the direction of the trend. When the bands contract (known as a band squeeze) it indicates lower volatility meaning the stock price is moving in a tighter range. Successful trading is possible in both cases.
How to create a Bollinger band
To create a Bollinger band on a stock price chart, a centerline is created using an exponential moving average. The most common moving average is a 20-day moving average.
After that price channels (or bands) are created by calculating one standard deviation above and one below the center line. The upper and lower bands become your price targets. If prices continually touch the upper band, it may be an indication that the stock is overbought which could signal that a pullback is coming. Conversely, prices that continually touch the lower band may be an indication that there is an oversold market for that security and an uptrend is getting ready to form.
Bollinger bands can be created automatically by most trading software programs. A 20-day moving average and two standard deviations are default settings, but the number of periods and standard deviation can be changed to suit the needs of traders.
Related terms that help explain the function of Bollinger bands
To help better understand what Bollinger bands can show traders, it’s important to understand some terms.
Trend line– a security’s trend line indicates price direction. When traders are looking for profitable, trades, they don’t want to fight a trend, and no stock will ever move in one direction all of the time. When a stock chart shows price action reaching a higher high or higher low, that indicates an uptrend, meaning the price is going up. Conversely, when a stock chart shows a stock reaching a lower high and a lower low, that is a negative trend, meaning the price is going down.
Moving average defines a mathematical result calculated by averaging data points over a period of time. On a stock chart, the moving average is a smooth line that is plotted over the day-to-day price changes to give a better view of the trend line. The reason why it’s called a moving average is that these averages are all time-specific, so each time new data is added, old data drops off and the average “moves”. As we look at different technical indicators there are two additional terms to understand:
Simple moving average (SMA)– To calculate a simple moving average, you take the mean of a set of values. In the case of a stock chart that is priced over a period of time. To calculate the simple moving average you add up the prices you are looking for and then divide by the number in that set. So to calculate a 10-day SMA, you would add the closing price of a stock for the last 10 trading days and divide it by 10. For a standard moving average, all values are weighted equally. Most Bollinger bands use a 20-day SMA as the default setting although some traders will choose a shorter or longer time period.
Exponential moving average (EMA)– this is a weighted average that assigns more value (or weight) to the most recent data points. In this way, it is more responsive than the simple moving average which is preferable for some traders. You’ll also notice that the exponential moving average is a key variable for some of the indicators below. The calculation for EMA is not middle-school math. But the good news is that if you’re serious about technical trading, most charting packages do the calculation for you.
Support level means a point of maximum support for buyers. It is the point where the number of buyers is greater than the number of sellers. On a stock chart, it is the peak right before a stock’s price goes down. There will be multiple support levels on a chart.
Resistance level means a point of maximum resistance by sellers. It is the point where the number of sellers is greater than the number of buyers. On a stock chart, it is the trough right before a stock’s price goes up. There will be multiple resistance levels on a chart. Support and resistance levels help traders identify where they want to enter (buy) or exit (sell) a position.
Standard deviation– this is a statistic that measures the historical volatility of an investment. A large standard deviation means that there a greater variance between its price and the mean, indicating a wider price range. Calculating the standard deviation requires assigning each data point a value (x, x1, etc.), the mean (M), and the number of data points (n). Most trading programs will provide the calculation for standard deviation.
How to notice trading signals using Bollinger bands
Because Bollinger bands measure volatility, they can help confirm both the direction of a stock’s price movement and the trend strength associated with that price action. In technical analysis, they provide several signals that help traders conducting either long or short trades. Two key concepts that traders look for when studying Bollinger bands are “Band Squeeze” and “The Breakout”.
Band Squeeze is represented visually when the Bollinger bands move closer to each other. This indicates a time of low volatility. Once a stock enters a period of low volatility, it can be a sign that a security is ready to enter a period of higher volatility that will move a stock higher or lower.
The Breakout is represented when prices move above the top band or below the lower band. By itself, a breakout is not a trading signal, but when a breakout occurs, it can be an indication that the security is entering a period of higher volatility because it is trying to break out of a tight range. However, evidence of a breakout is not a stand-alone indicator of future price action. This will be discussed as you read about the limitation of Bollinger bands.
To set up a long trade, investors will look at a basic candlestick chart for an indication of when the stock closed above the previous day’s close (a filled green candlestick where the body, not just the wick is above the previous day’s close) and second when the close was above its most recent high.
To set up a short trade, investors will look for an indication of when the stock closed below the previous day’s close (a filled red candlestick where the body, not just the wick is below the previous day’s close) and also when it closed at a low below its most recent low.
Limitations of Bollinger bands
Bollinger bands are one of many technical indicators that traders use, and they can be effective for beginning traders who are looking for signals to enter and exit trades. However, like many technical indicators, they have some limitations. Some of the more common ones are listed below.
- Bollinger bands are reactive, not predictive– Bollinger bands show price volatility. They are excellent at showing overbought or oversold conditions, however, they do not indicate whether buying pressure or selling pressure (i.e. momentum) will continue. In some cases, the momentum of a stock’s price action will extend well after the upper or lower band has been breached. Bollinger bands also do not indicate with certainty when a breakout pattern will begin.
- Bollinger bands work best when markets are moving in a tight, predictable range– Bollinger bands can be thought of as a floor and a ceiling with stock prices bouncing between the two. When markets are changing quickly or investor sentiment is changing rapidly, Bollinger bands become less accurate. In the same way, Bollinger bands can be slow to react, and therefore be less reliable when the market or a particular security is affected by adverse news.
- Bollinger bands can be difficult for novice traders to use – Most tutorials of Bollinger bands are showing price action that has already happened. This makes it easier to see the right times to make trades. But when tracking Bollinger bands in real time, a chart pattern can be much more difficult to pick out.
- Bollinger bands can produce false buy or sell signals – When volatility is low and the bands contract, it can be more likely that prices will bounce between the upper and lower band. However, this is not always seen as a reliable indicator, particularly for day trading.
- Default settings may not fit all trading styles – Typical defaults on trading software will be to show Bollinger bands with a 20-day moving average and two standard deviations (one above and one below the moving average). However, these settings don’t fit all trading styles. For example, active traders such as day traders may require a shorter moving average or less standard deviation. Long traders may want a longer moving average or more standard deviation.
- Bollinger bands do not provide real-time input – Because Bollinger bands are calculated based on a standard moving average (SMA), there is always a delay that traders should be aware of.
- Bollinger bands show where prices are at a moment in time and cannot be used to predict historical trends – Traders know that the price of a security will tend to repeat itself over time, but Bollinger bands only show where volatility is at a given moment.
The bottom line on Bollinger bands
Bollinger bands are a technical analysis tool that along with a simple moving average (SMA) measures the market volatility associated with a particular security. A Bollinger band is represented by two lines one above and one below a standard moving average. In most cases, a default Bollinger band will show a band one standard deviation above and one standard deviation below a 20-day standard moving average. Bollinger bands were the creation of John Bollinger, a renowned technical trader.
The two concepts that help inform trades using Bollinger bands are Band Squeeze and The Breakout. Band Squeeze defines periods where the band widths contract which indicates volatility is low and the security may be entering a period of high volatility. The Breakout is a point where the price of a security breaches either the top or bottom band. This can be another signal that a stock is trying to break out of a tight range.
Although Bollinger bands can be a helpful tool that gives investors a higher probability of success, they are not considered a stand-alone indicator. One of the key reasons for this is that they are inherently a reactive tool more than a predictive tool. In fact, the more volatility associated with a security, the less reliable the Bollinger bands will be.