Knowledge Series XIII : What are Bollinger Bands & How they can be used for trading activity.
Bollinger Bands are technical analysis tools developed by John Bollinger in the 1980s for trading in stocks. The bands comprise a volatility indicator that measures the relative high or low of a stock’s price in relation to previous trades. Bollinger bands are a popular form of technical price indicator. They are made up of an upper and lower band, set either side of a simple moving average (SMA). Each band is plotted two standard deviations away from the SMA of the market, and they are capable of highlighting areas of support and resistance. (Standard deviation is a mathematical formula that measures volatility). Due to their dynamic nature, Bollinger bands can be applied to the trading of various assets.
How to calculate Bollinger bands
Bollinger bands are calculated using three lines drawn onto a price chart. The first line is the SMA of an asset’s price, usually within a 20-day period. The upper band is the SMA plus two standard deviations, while the lower band is the SMA minus two standard deviations.
To calculate the SMA, you would take the closing prices for the number of days that you were looking at (normally 20 days) and divide the total sum of all the closing prices by the total number of days.
Once you have the SMA, you can calculate the upper and lower bands:
– The upper band = 20-day simple moving average plus (20-day standard deviation multiplied by 2)
– The lower band = 20-day simple moving average minus (20-day standard deviation multiplied by 2)
Most trading platforms will calculate Bollinger bands for you automatically, but it is still useful for a trader to know what the different bands mean and what can be learnt from them.
What do Bollinger bands tell traders?
Many traders believe that Bollinger bands are an accurate indicator of market volatility. If the bands are wider, it means that a market is more volatile; while narrower bands mean that a market is more stable.
Traders also look for Bollinger ‘squeezes’ and Bollinger ‘bounces’, which are used as indicators for levels of support and resistance.
Squeezes : when the upper and lower band contract toward the moving average, it could show that there is about to be a breakout of the asset’s price.
Bounces : which occur when the price movement hits the upper band and bounces back down, this might be indicative of an upcoming retracement.
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 have perhaps fallen too much and are due to bounce. On the other hand, when price breaks above the upper band, the market is perhaps overbought and due for a pullback.
Using the bands as overbought/oversold indicators relies on the concept of mean reversion of the price. Mean reversion assumes that, if the price deviates substantially from the mean or average, it eventually reverts back to the mean price. However, just like other indicators, Bollinger bands are not always 100% accurate. The information these bands provide should be used in combination with other forms of analysis.
Source : ig.com