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!
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.
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).
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.
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.
Here are some of the trading strategies which you can use after assessing the Bollinger Bands for a particular stock:
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.
Here are some benefits of this band:
This tool also suffers from certain limitations, which are as follows:
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.
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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Want to put your savings into action and kick-start your investment journey 💸 But don’t have time to do research? Invest now with Navi Nifty 50 Index Fund, sit back, and earn from the top 50 companies.
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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