Exploring Bollinger Bands®: Understanding Their Significance for Investors

Mastering the art of technical analysis is a vital skill for investors who want to succeed in the stock market. One such tool that has gained widespread popularity among traders is the Bollinger Band®. Developed by John Bollinger, this technique consists of two standard deviation trendlines plotted on either side of a simple moving average (SMA). The concept behind Bollinger Bands® is to provide traders with a better understanding of when a stock is oversold or overbought, which can help them make better trading decisions. With adjustable settings, investors can customize the bands to fit their trading preferences and strategies.

If you’re interested in using Bollinger Bands® to analyze securities, the first step is to calculate the simple moving average (SMA), which is typically done using a 20-day SMA. This involves averaging the closing prices for the first 20 days to determine the first data point. From there, each subsequent data point drops the earliest price, adds the price on day 21, and takes the average, and so on. After calculating the SMA, the next step is to obtain the standard deviation of the security price. Standard deviation is a statistical measure of average variance and is commonly used in finance, economics, accounting, and statistics.

Standard deviation is a statistical measure that quantifies the amount of variation or dispersion in a set of data from its average or mean value. It is computed as the square root of the variance, which represents the average of the squared deviations of each data point from the mean.

The subsequent step is to multiply the value of the standard deviation by two and add and subtract that quantity from each point on the simple moving average. This process generates the upper and lower bands.

Here is the Bollinger Band® formula:
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BOLU = MA(TP,n) + m ∗ σ[TP,n] BOLD = MA(TP,n) − m ∗ σ[TP,n] where:
BOLU = Upper Bollinger Band
BOLD = Lower Bollinger Band
MA = Moving average
TP (typical price) = (High + Low + Close) ÷ 3
n = Number of days in smoothing period (usually 20)
m = Number of standard deviations (usually 2)
σ[TP,n] = Standard Deviation over last n periods of TP
​

Bollinger Bands® have become a staple for many traders looking to identify potential oversold or overbought markets. According to this popular technique, the closer a security’s price moves towards the upper band, the more overbought the market becomes. Conversely, the closer the price moves towards the lower band, the more oversold the market becomes. To help traders make the most of this tool, the creator of Bollinger Bands®, John Bollinger, has laid out 22 rules to follow when using the bands as a trading system. These guidelines can be an excellent resource for traders looking to improve their strategies and potentially increase their chances of success in the market.

Let’s take a closer look at the central concept of Bollinger Bands® – the “squeeze”. This occurs when the bands come close together, causing the moving average to constrict. Traders often view a squeeze as a sign of low volatility, indicating that the market may be preparing for increased volatility and potential trading opportunities in the future.

However, it’s important to keep in mind that wider bands do not necessarily indicate trading signals. In fact, the wider the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. It’s important to note that the bands themselves do not indicate when a change will occur or in which direction the price may move. As always, careful analysis and consideration of market trends is key to successful trading.

Did you know that approximately 90% of price action takes place between the two Bollinger Bands®? A breakout above or below the bands can be a significant event. However, it is important to note that a breakout is not a trading signal, and many investors make the mistake of thinking that hitting or exceeding one of the bands is a signal to buy or sell. In reality, breakouts do not provide any information about the direction or extent of future price movements. It’s essential to use additional technical analysis tools and trading strategies to make informed decisions.

Bollinger Bands® may not be a magic solution for trading success, but they can be a valuable tool for understanding price volatility. To get the most out of them, traders should use Bollinger Bands® alongside other indicators that provide more direct market signals and data. John Bollinger recommends using two or three non-correlated indicators, such as MACD, on-balance volume, and RSI, to complement Bollinger Bands®.
It’s worth noting that because Bollinger Bands® rely on a simple moving average, they give equal weight to older price data as they do to the most recent. This means that new information may be diluted by outdated data. Additionally, the use of a 20-day SMA and 2 standard deviations may not work for every situation, and traders should be prepared to adjust their assumptions accordingly. By monitoring their SMA and standard deviation assumptions, traders can better understand and use Bollinger Bands® to inform their trading decisions.

Bollinger Bands® is a valuable tool that traders use to track the market’s price movement. This technique uses three bands, including an upper band, a lower band, and a moving average band. When prices get closer to the upper band, it’s an indication that the market may be overbought. In contrast, if prices are closer to the lower or bottom band, it suggests that the market might be oversold. By analyzing these movements, traders can make more informed decisions about when to enter or exit trades.

In the world of technical analysis, combining different indicators can provide a more complete picture of market movements. Bollinger Bands® are no exception and can be effectively used in conjunction with other indicators like the relative strength indicator (RSI) and BandWidth. The BandWidth indicator measures the width of the bands relative to the middle band and is often used by traders to spot Bollinger Squeezes.

Given that Bollinger Bands® are set at two standard deviations above and below an SMA, it is reasonable to anticipate that around 95% of the time, the observed price action will remain within these bands.

The usual practice for Bollinger Bands® is to employ a simple moving average of 20 days.

Bollinger Bands® are a powerful tool for traders looking to gain insight into the market’s movements and identify potential buying and selling opportunities. By tracking the relative levels of over- or under-sold positions of a stock, Bollinger Bands® help traders determine when it’s time to enter or exit a position. This technique is particularly useful in currency trading, where sudden price movements can make or break a trade. For example, buying when stock prices cross below the lower Bollinger Band® can signal an oversold condition, indicating that it’s time to buy and potentially profit when the stock price moves back up toward the center moving-average line. With Bollinger Bands® as part of their trading toolkit, traders can make more informed decisions and improve their chances of success in the market.