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.
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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.