What are Bollinger Bands?

Bollinger Bands are a technical analysis tool defined by three trend lines: a simple moving average (SMA) of the price, and two standard deviation lines +/- from the SMA (the upper and lower bands) that can be adjusted according to the user's preference.

Bollinger Bands were developed and copyrighted by the renowned technical trader John Bollinger. They are designed to detect opportunities that help investors more accurately determine whether an asset is overbought or oversold.

How to Calculate Bollinger Bands

The first step in calculating Bollinger Bands is to calculate the SMA, typically using a 20-day SMA.

• Upper Band = 20-day SMA + 2 x 20-day Standard Deviation (middle band plus 2 standard deviations)

• Lower Band = 20-day SMA – 2 x 20-day Standard Deviation (lower band minus 2 standard deviations)

Significance of Bollinger Bands

Bollinger Bands are a very popular technique. Many traders believe that the closer the price moves to the upper band, the more overbought the market is, and the closer the price moves to the lower band, the more oversold the market is. John Bollinger created a set of 22 rules to follow when using the bands as a trading system.

In the chart described below, Bollinger Bands surround a stock’s 20-day SMA with the upper and lower bands representing the daily price movements of the stock. Standard deviation is a measure of volatility, so when the market is more volatile, the bands widen, and during less volatile periods, the bands narrow.

Bollinger Bands Squeeze

The squeeze is an important concept of Bollinger Bands. When the bands come closer together and create a bottleneck around the moving average, it is a potential sign that volatility will increase in the future and that trading opportunities may appear.

Conversely, when the bands are far from the moving average, it indicates a higher likelihood of decreased volatility and an opportunity to exit positions. However, these occurrences are not trading signals, as they do not indicate whether the price will move up or down.

Breakout

Approximately 90% of price action occurs between the upper and lower bands. Any time the price breaks above or below these bands, it is a significant event. A breakout is not a trading signal either. The common mistake that most people make is believing that touching or surpassing one of the bands is a signal to buy or sell. A breakout does not provide clues about the future direction or magnitude of price movement.

Limitations of Bollinger Bands

Bollinger Bands are not a standalone trading system. They are simply an indicator designed to provide traders with information about price volatility. John Bollinger recommends using them with two or three other uncorrelated indicators that provide more direct market signals. He believes it is important to use indicators based on different types of data. Some of his favorite technical tools to use alongside Bollinger Bands are MACD and RSI.

Because Bollinger Bands are calculated from a simple moving average (SMA), they give equal weight to old price data and recent prices. This means that new information may be diluted by old data. Additionally, using a 20-day SMA and 2 standard deviations is an option that may not be effective for everyone in all situations. Traders should adjust their SMA and standard deviation assumptions accordingly and monitor them.

According to Investopedia