If you’ve read through Part – I of our Bollinger Band series, it’s time to look into some applications of Bollinger Bands and trading strategies you can build around them.

1. Following Trends using Bollinger Bands

Bollinger bands are used for measuring deviation, and therefore, this indicator can be very beneficial in recognizing a trend. We can generate two sets of Bollinger bands, one set with the help of “0.5 standard deviation” and the other using “3 standard deviations”.

In the chart of Tata Consultancy Services shown below, we can observe that whenever the price holds between the upper Bollinger Bands +0.5 SD and +3 SD away from the mean, the trend is in the upward direction, and therefore, this channel is known as the “buy zone.”

Contrarily, if the price is within the Bollinger Bands –0.5 SD and –3 SD, it is referred to as the “sell zone.” Finally, if the price moves between the +0.5 SD band and –0.5 SD band, then it is in a “neutral zone.”

Bollinger Bands keep on adapting to the expansions and contractions in price, because of the increase and decrease in volatility. Because of this, bands widen and narrow down in sync with price action, creating a highly accurate trending envelope.

Coming back to the chart again, the trader may take a long position when the price enters the “buy zone”. The trader’s target should be able to stay with the move for most of the uptrend and exit only when the price starts to consolidate at the top of the new range. An exit from this trade should be made when a red candle is formed and more than 75% of the candle’s body is below the “buy zone”.

2. Squeeze and Breakout Strategy using Bollinger Bands

This trading strategy is based on predicting price breakouts using volatility.

The volatility of the market is constantly changing from low to high and vice versa. This implies that if the market is in a low volatility phase, eventually, volatility will pick up in the future, leading to large price movements and breakouts.

Bollinger Bands can be used both for intraday and swing trading, depending upon the time frame which the trader wants to use.

For using this strategy, we need to find conditions of low volatility or specific less volatile markets and predict when a breakout might happen and in which direction it will be.

For this purpose, we need to find a market that is moving in a range. We can quickly identify this by looking at the middle SMA line. The line needs to be relatively flat, as shown in the chart of Nazara Technologies Ltd., and the two bands must be close to each other.

This task can be made easier by using an indicator called the BBW or Bollinger Bands Width. You can easily get this on a trading platform. This tool shows the distance between the two bands.

If the BBW is low, it means the gap between the two lines is close, and if it is high, it means that the gap is set further apart. The two indicators need to have the same settings for them to work.

Further, to predict the price breakout, we need to wait for the standard deviation lines to start expanding, which can be easily identified by the rise of the BBW. This means that there’s an increase in volatility and a breakout is likely to occur.

The direction of the breakout depends upon whether the candle is breaking the upper line or the lower line. Accordingly, selling or buying of stocks is done.

In this chart of Nazara Technologies Limited, we are using a 15-min time frame. We can observe a flat SMA, meaning that the market is in a range and the two bands are contracting, which a low BBW confirms.

After some time, the bands start to expand, which is also confirmed by the rise in BBW. Then, a red candle breaks out of the lower line, which is an excellent opportunity to take a sell position and make an entry. The lowest point of this same candle is taken as “Stop Loss.”

As shown in the figure, the exit should be made when the price breaks the middle SMA line.

Let’s look at another example.

In this chart, we are analyzing Wipro Limited with a time frame of 1 day.

We can observe that the market is in a range as shown by the flat SMA, and the gap between the two bands is close, which is also represented by a low BBW.

Next, we can see that the bands are starting to expand, confirmed by the rising BBW. Then, a green candle breaks out of the upper line, and this is an excellent opportunity to take a buy position and make an entry.

The lowest point of this same candle can be set as stop loss. As shown in the figure, the exit should be made when the price breaks the middle SMA line.

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Among the many trading indicators used for technical analysis, Bollinger bands are a popular technical indicator. Bollinger bands are a momentum indicator used to characterize price and volatility.

What are Bollinger Bands?

Bollinger Bands are a technical analysis tool defined by a set of 3 lines.

The middle line depicts a simple moving average of a stock’s price while the upper and lower lines depict positive and negative standard deviations, respectively, which the user can adjust to one’s preference using a technical analysis charting software.

Bollinger Bands were introduced by John Bollinger, and no prize for guessing, they have been named after him.

How to calculate Bollinger Bands?

As seen in the picture above, Bollinger Bands consist of 3 lines.

The first one in the middle is a simple moving average line usually calculated using the 20-day simple moving average or SMA of the security we are analyzing.

The next two lines, i.e. the upper and lower lines depict the standard deviation of the security’s price we are analyzing.

The upper line denotes positive standard deviation and the lower line shows negative standard deviation. Typically, the upper and lower lines are 2 standard deviations higher and lower from the simple moving average line, respectively.

In the PHI 1 image above, the red line signifies the 20-day moving average and the standard deviations are +/-2, which is the default setting on a trading platform.

Standard deviation is a method to measure the average variance, i.e., how spread out the numbers plotted on a chart are from an average value.

You have the option to change the gap between the SMA line and the positive and negative standard deviation lines on a technical analysis charting software. We skip the formula for calculating Bollinger Bands as they are available easily on the charting tool you may use.

What do Bollinger Bands tell you?

Bollinger Bands are used by traders to identify when a security is oversold or overbought.

As mentioned above, standard deviation shows the price variance of the security from the simple moving average.

So, as the lower and upper line gap widens, it shows more price volatility, and as the lower and upper line gap contracts, it depicts less volatility.

Bollinger Bands can also be used for trend following and to identify breakouts.

Identifying overbought and oversold conditions with Bollinger Bands

The rule is simple:

When the security’s price breaks below the lower band, it may be oversold and due for a bounce-back.

When the security’s price breaks above the upper band, it could be overbought and due for a pullback.

Thus, the closer the price of a security goes to the upper standard deviation line, the more overbought security is believed to be, and the closer the price moves to the lower standard deviation line, the more oversold the security could be.

This rule is based on the premise of mean reversion, which assumes that if a price moves too far away from the average, it will eventually return to the mean.

(Watch this space for more trading strategies using Bollinger Bands. Subscribe to our blog.)

Limitations of Bollinger Bands

1. It should be noted that Bollinger Bands are not a standalone trading indicator.

They only provide insights regarding price volatility to traders. It is always advisable to use them in combination with other technical trading indicators.

2. Bollinger Bands don’t always give the correct buy and sell signals.

For instance, with a strong trend, you may risk placing trades on the wrong side, as the indicator may give overbought or oversold signals too early.
You can avoid this by considering the overall direction of price.

3. They are calculated using a 20-day SMA.

Here, the weightage given to older data is the same as more recent data, which may cause the older data diluting the newer and more relevant data.

Also, the 20-day SMA setting with +/- 2 standard deviation may not be suited for each security in all market conditions. Traders need to use their discretion to adjust the SMA and standard deviation as per their assumptions.

All said and done, Bollinger Bands are still the rockstars of trading indicators.

You can access them along with over 120 other indicators on a trading software like PHI 1, which lets you customize them based on your needs.

You can accomplish charting, screening, strategy creation and testing, simulation, and order execution all in one unified trading software.