What are Bollinger Bands – Its Formula, Strategy and What It Interprets
Bollinger bands serve as a volatility indicator of stocks. The Bollinger bands trading strategy was developed by John Bollinger during the 1950s. This tool uses a set of trendlines which gets plotted above and below the moving average line of the respective security’s price using standard deviation. The resultant gap between moving average lines and price points represents market volatility. Higher the gap between them indicates a higher level of volatility and vice versa.
So, can Bollinger bands signal market trends? This article provides an in-depth understanding of Bollinger bands. Read on!
How Do Bollinger Bands Work?
This technical tool mainly deals with three components, namely the upper band, lower band and middle band. The upper and lower bands are standard deviations of that particular stock, and middle one represents the simple moving average. All these three structures amalgamate to produce a price envelope.
You can use moving average values for 20 days for carrying out a short-term analysis. On the other hand, to consider long term analysis, simple moving average values of 200 days may be sufficient. You have the liberty to decide a number of standard deviations for setting volatility indicators. The quantity of standard deviations determines the distance between the upper and lower band and the middle band. Positioning of standard deviations gives an idea about the future trends of security.
Whenever the price of a security breaches the upper band, it is a signal for sell off. On the other hand, a buying trend starts when price points touch the lower band.
What is the Bollinger Bands Formula?
The formula for Bollinger bands strategy is as follows:
The first step is to compute the standard deviation, which is as follows:
σ = √Σ(X-µ)/n;
Here, σ represents the popular standard deviation;
Σ means summation;
µ represents the population mean; and
n implies a number of scores.
Now that you know the value of popular standard deviation let’s shift our focus to the computation of other components.
Upper Bollinger Band = MA (TP, n) + m*σ [TP, n];
Lower Bollinger Band = MA (TP, n) – m*σ [TP, n];
Here, MA represents moving average;
TP or typical price is (close+ high+ low)/3;
n represent days for moving average calculation, preferably 20 days;
m is number of standard deviations (usually it is 2);
σ [TP, n] represents standard deviation over the last n days of typical price (TP).
How to Use Bollinger Bands?
There are two main ways of using it. The first method is known as squeeze and second is the breakout. Bollinger bands squeeze leads to a reduction in the width of bands, making them narrower or tighter. This signifies low volatility in that market.
Moreover, it means that a period of high volatility is approaching the market, and it may lead to tremendous oscillation in price points. It will either breach the lower band or the upper band, depending on prevailing market conditions. Many analysts believe that a period of squeeze is the best time for trading in securities.
When price points close above the upper band, it implies a positive volatility breakout. On the other hand, when price points close below the lower band, this implies a negative volatility breakout. You can go on a buying spree when there is a positive breakout and engage in heavy selling during times of negative breakouts.
How to Interpret Bollinger Bands?
The main goal of these bands is to give an idea about volatility prevailing in the markets. The width or gaps between moving average lines and price bands indicates the level of volatility. Whenever bands move farther away from the moving average line, it implies high volatility. On the other hand, closing in of Bollinger bands towards the moving average line indicates lesser volatility.
Therefore, we can see that the gap between bands and the average line is directly proportional to volatility. Traders also get an idea of whether a particular stock is oversold or undersold by analysing these bands. A movement of price closer to the upper band implies overbuying of stocks. Similarly, when the price of the security is hovering near the lower band, it indicates a strong overselling undercurrent in that particular security.
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What is the Bollinger Bands Strategy?
Here are some of the trading strategies which you can use after assessing the Bollinger Bands for a particular stock:
- You can go for buying a stock or adopt a long position when price points breach the upper bands. Whereas selling or taking a short position is ideal in situations of downside movement of price point towards the lower band.
- When you get a W pattern in Bollinger bands, you can buy securities priced near the lower bands. However, you can go ahead with this only when other indicators also confirm the same trend.
- You can also sell that particular security when there is weakness in the market as the price approaches lower bands. Again, you should trade only when other indicators confirm the same trend.
Moreover, you can go ahead with buying securities when the price point is nearer the upper Bollinger band. However, you should look out for confirmation of trends using other indicators.
What Are the Benefits of Bollinger Bands?
Here are some benefits of this band:
- This tool is easy to interpret, which allows investors to arrive at conclusions swiftly. Indicators of Bollinger bands are quite easy to understand, even for new traders.
- One can get an idea of the prevalent volatility in the markets. Moreover, on a closer look, you can also get an idea regarding momentum oscillations happening.
- It is a highly flexible tool. You can use them on a variety of assets across different timeframes.
- Exit entry strategies, stop loss as well as take-home profits – you can easily understand all these components from Bollinger bands and experience hassle free trading.
Limitations of Bollinger Bands
This tool also suffers from certain limitations, which are as follows:
- It may not work efficiently in trending market conditions. John Bollinger developed this tool by only keeping the sideways market in mind.
- These signals may not be reliable every time. Error in data collection and interpretation may lead to conflicting signals.
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Final Word
Bollinger bands are a technical analysis tool which traders use to gauge volatility in stock markets or concerned securities. It also gives various trading signals that you may use to take an appropriate position in the market. Investors are advised to use Bollinger bands with other technical analysis tools before taking a long or short position while trading.
FAQs on Bollinger bands
Ans: The common M-top signals in Bollinger bands are double tops, diamonds and head and shoulders. It creates an ideal M-top pattern when the price level breaches the upper band.
W-bottoms are double bottoms and inverted shoulders. It forms when the price level touches lower bands.
Ans: You need to compute the difference between the upper and lower bands and divide the same with the middle band to derive the value of width. The bandwidth increases whenever these bands expand. However, it decreases during times of contraction of Bollinger bands.
Ans: Yes, the Bollinger band is a lagging indicator. This is because, like lagging indicators, this tool also provides delayed feedback. It triggers the signal for buying or selling when price movements are complete.
Ans: Bollinger bands can be used with a combination of technical analysis indicators such as moving averages, Relative Strength Index, stochastics, support and resistance and any other trading research tools.
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