The Basics of Bollinger Bands
Bollinger Bands is a technical analysis tool developed by John Bollinger. They consist of three lines plotted on a price chart: the middle band (usually a simple moving average) and an upper and lower band, typically placed two standard deviations away from the middle band.
Bollinger Bands are popular among technical analysts and traders due to their ability to capture price volatility, identify overbought or oversold conditions, and highlight price reversals or breakouts. However, using Bollinger Bands in conjunction with other technical indicators and analysis techniques is essential to increase the accuracy of trading decisions.
Why Were Bollinger Bands Created?
John Bollinger created Bollinger Bands as a technical analysis tool to provide a framework for trading and interpreting price volatility. He developed the concept in the 1980s, aiming to address the limitations of traditional moving averages for volatility assessment.
Why Were Bollinger Bands Created?
Bollinger Bands were created to achieve several objectives. Bollinger intended to develop a tool to effectively measure and depict market volatility levels. Traditional moving averages were static, providing limited information about market volatility. On the other hand, Bollinger Bands dynamically adjusts based on the market's price action, expanding during periods of high volatility and contracting during low volatility periods.
Bollinger Bands were designed to identify potential overbought and oversold conditions in the market. By utilizing standard deviations to calculate the upper and lower bands, Bollinger aimed to outline price levels that were statistically significant and potentially indicated a reversal or continuation of the current trend.
Bollinger Bands can assist in recognizing various chart patterns, such as price breakouts, trend reversals, and price squeezing. By incorporating price action within the bands' boundaries, Bollinger aimed to provide traders with visual cues for potential trading opportunities based on chart patterns.
Bollinger intended for the Bollinger Bands to be simple to understand and interpret. The concept of the bands is relatively straightforward, making it accessible to novice and experienced traders alike.
What are the Basics of Bollinger Bands
The middle band represents the average price over a specified period, usually using a simple moving average (SMA). The most common period used is 20 periods, but you can adjust it based on your preference or trading strategy.
The upper band is calculated by adding two standard deviations to the middle band. It indicates the potential overbought level of the asset or security being analyzed. When prices touch or exceed the upper band, it suggests a possible overbought condition or price reversal.
The lower band is calculated by subtracting two standard deviations from the middle band. It indicates the potential oversold level of the asset or security being analyzed. When prices touch or fall below the lower band, it suggests a possible oversold condition or price reversal.
Bollinger Bands are based on the concept of volatility. The width of the bands expands when market volatility is high and contracts when volatility is low. The bands widen during periods of increased price volatility and narrow during periods of decreased volatility.
Bollinger Bands can help identify potential price reversals. When prices touch or exceed the upper or lower band, it may suggest a change in direction. Traders often look for reversals or price bounces near the bands.
Bollinger Bands are more effective when used with other technical indicators or chart patterns. Traders often look for confirmation from other indicators, such as momentum oscillators or trend lines, to validate potential trading signals generated by Bollinger Bands.
How Are Bollinger Bands Used?
Several trading strategies incorporate Bollinger bands. The Bollinger Breakout strategy takes advantage of periods of low volatility followed by a breakout. When the Bollinger Bands contract, indicating low volatility, traders anticipate a potential price expansion. They wait for a breakout, which occurs when prices move above the upper band or below the lower band. A long trade is initiated if the breakout is above the upper band, and a short trade is initiated if the breakout is below the lower band. Traders often use other indicators or chart patterns to confirm the breakout before entering such trades.
A Bollinger Band Reversal seeks to identify potential price reversals by using Bollinger Bands. When prices touch or exceed the upper band, it suggests an overbought condition and a possible price reversal. Conversely, when prices touch or fall below the lower band, it suggests an oversold condition and a potential price bounce. Traders may enter short positions when prices touch the upper band and long positions when prices touch the lower band, aiming to capture a reversal in the price.
A Bollinger Band Trend-Following is a strategy where Bollinger Bands are used to confirm an established trend and identify potential entry and exit points. During an uptrend, prices stay near the upper band, while prices stay near the lower band in a downtrend. Traders may look for pullbacks to the middle band (moving average) as potential entry points in the direction of the trend. They may exit the trade when prices touch the opposite band or the trend shows signs of reversing.
A Bollinger Band Breakout with Confirmation strategy combines Bollinger Bands with other indicators or chart patterns to validate breakout signals. Traders may wait for a breakout above the upper band or below the lower band and then look for confirmation from momentum oscillators, such as the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD), before entering trades. This approach aims to reduce false breakouts and increase the probability of successful trades.
A Bollinger Band, Multiple Timeframe Analysis, uses Bollinger Bands on different timeframes (e.g., daily and hourly charts) to gain a broader market perspective and identify potential trade setups. For example, they may use the daily Bollinger Bands to identify the overall trend and the hourly Bollinger Bands to pinpoint entry and exit points. This strategy helps traders align their trades with the more significant market trend while fine-tuning their entries based on shorter timeframes.
How are Bollinger Bands Calculated?
Bollinger Bands have three parts: the middle band and the two surrounding bands. The middle band is typically calculated as a simple moving average (SMA) of the closing prices over a specified period. The most commonly used period is 20, but you can adjust it based on your preference or trading strategy.
The outside bands are the standard deviation is a statistical measure of the spread or volatility of prices. It quantifies how far individual prices deviate from the average. To calculate the standard deviation, you take the difference between each closing price and the middle band, square the differences, sum them up, divide by the period, and then take the square root of the result.
Calculate the SMA as the middle band using the closing prices over the last 20 periods.
Calculate the standard deviation by taking the difference between each closing price and the SMA, square the differences, sum them up over the 20 periods, divide by 20, and then take the square root of the result.
Calculate the Upper and Lower Bands: Once you have the middle band (SMA) and the standard deviation, you can calculate the upper and lower bands. The upper band typically sets two standard deviations above the middle band. Add two times the standard deviation to the middle band to calculate it. The lower band typically sets two standard deviations below the middle band. To calculate it, subtract the standard deviation from the middle band two times.
These calculations allow you to plot the Bollinger Bands on a price chart. The middle band represents the average, and the upper and lower bands represent the ranges within which prices are expected to stay most of the time.
What Indicators Would You Use with Bollinger Bands?
There are several indicators that traders often use in conjunction with Bollinger Bands to enhance their analysis and trading decisions.
The RSI can help identify overbought and oversold conditions. Traders often look for divergences between the RSI and price action when prices reach the upper or lower Bollinger Band, which may provide additional confirmation for potential reversals.
The MACD is a trend-following momentum indicator that helps identify potential trend reversals and confirm trend strength. Traders may look for MACD line crossovers or divergences with price action near the Bollinger Bands to validate potential trading signals.
The Stochastic Oscillator helps identify overbought and oversold levels. Traders may consider potential reversals or trend continuation signals when the Stochastic Oscillator reaches extreme levels (e.g., above 80 or below 20) near the Bollinger Bands.
Traders often use candlestick patterns, such as doji, engulfing, or hammer, in conjunction with Bollinger Bands to identify potential reversals or continuation signals. A candlestick pattern forming near the upper or lower band may provide additional confirmation for a trading decision.
The Bottom Line
John Bollinger created Bollinger Bands as a comprehensive tool to analyze market volatility, identify potential overbought or oversold conditions, and recognize chart patterns. The wide adoption of Bollinger Bands by traders and analysts can be attributed to their simplicity, versatility, and effectiveness in understanding market dynamics.
This article was written in cooperation with Aqib Ljaz