A Crash Course On Technical Analysis, Part Six: Bollinger Bands


January 29  

This is part six of a series on technical analysis covering Bollinger Bands. Click here for the series overview in part one. Click here for part two on the history of technical analysis. Click here for part three on an overview of candlestick charts. Click here for part four on basic candlestick patterns. Click here for part five on advanced candlestick patterns.

Another important tool in technical analysis is a type of chart called Bollinger Bands, which were developed by technical trader John Bollinger in the 1980s and then trademarked in 2011. These charts have three lines, or bands, on them. The middle line is usually the simple moving average of the price of the security being tracked. In most cases, traders use the 20-day simple moving average, although this can be adjusted.

Some traders prefer to use the exponential moving average instead of the simple moving average, which complicates things. In any case, the lines on both sides of the moving average usually mark two standard deviations above and below the moving average, although they can be adjusted as well.

Calculating the Bollinger Bands

The 20-day simple moving average is always based on the closing prices of the last 20 days. It takes the closing price of each of the 20 days, adds them together, and then divides by 20 to get the average. Every time a new day is added, it drops the first day from the previous 20 days, adds on the new day, and takes the average of those 20 days to plot the new data point.

After plotting the simple moving average, the other two Bollinger Bands are calculated as standard deviations from the average. A standard deviation is a number that represents the extent of variation in a group. In technical analysis, standard deviations are used to measure the spread of numbers compared to average values.

The standard deviations for the Bollinger Bands are calculated as the square root of the difference between the moving average and the upper and lower bands. This difference is the average of the squared differences of the mean. When the difference is higher, it means there’s a greater variation between the mean and each data point, which results in a wider gap between the bands and signals increased volatility. The mean is calculated by adding all the data points in the set and then dividing by the number of data points, which would be 20 in the case of the 20-day simple moving average.

To get the value of the upper band, you multiple the standard deviation by two and then add that to the simple moving average. To get the lower band, you multiple the standard deviation by two and subtract it from the simple moving average. Computers have made it significantly easier to calculate standard deviations and Bollinger Bands instead of trying to do it by hand.

Signals indicated by price movements within Bollinger Bands

The more volatile the price being tracked becomes, the wider the bands will be. When the price stays close to the simple moving average, it’s referred to as a squeeze. Volatility is low during a squeeze, which is often considered to be a sign that volatility will increase meaningfully in the coming days. Greater volatility can present more trading opportunities if they are executed correctly. On the other hand, the wider the bands there are, the more volatile the price is, which suggests a period of low volatility may be just around the corner. Of course, these are vast generalities, and it depends greatly on which asset is being tracked and what is happening in the market at the given time.

When the price repeatedly touches the top band, the asset is generally considered to be overbought, triggering a sell signal for some traders. When it repeatedly touches the bottom band, it’s considered to be oversold, which triggers a buy signal for some traders. If the price has been steadily trading between the simple moving average and the lower band but suddenly breaks above the average, it could be a signal that a bullish reversal is about to occur. The inverse is true when the price has been consistently trading between the moving average and the upper band but then suddenly breaks below the moving average.

On the very rare occasion that the price breaks outside the upper or lower bands, it’s considered a major event to watch, although it is not usually a buy or sell signal. The problem is that a breakout doesn’t signal where the price might be going next. According to Bollinger’s own rules for using the bands, a breakout is generally considered a continuation signal rather than a sign of a reversal. However, the continuation must be confirmed in future data points.

How Bollinger Bands are used in trading

Traders interpret Bollinger Bands in different ways. Some buy the asset when the price touches the bottom band and then sell when it touches the middle band. Others buy when the price breaks above the top band or sell when the price falls below the bottom band.

Stock traders aren’t the only ones who use Bollinger Bands. Options traders also use them, especially those who focus on implied volatility. Options traders often sell their options when the Bollinger Bands are especially far apart or buy options when the bands are very close together. In both cases, the assumption is that volatility is expected to revert to the historical average.

The bands can be applied to all assets, including everything from stocks to commodities and currencies. Because of the ease of adjusting them to different parameters, they are very versatile. They give traders a frame of reference as far as whether the price is relatively high or relatively low.

Bollinger Bands should never be used alone

One problem with Bollinger Bands is that they weight older prices in a range the same as more recent prices, which means outdated information may still be factored into the price. For this reason and others, Bollinger Bands should never be used on their own to track and predict the market’s movements. They are one tool designed to inform on levels of volatility within an asset’s price.

Traders are advised to use other tools along with Bollinger Bands to track other aspects of technical analysis, such as relative strength, volumes, exact price movements rather than changes in the moving average, or chart patterns. When used in conjunction with chart patterns, the bands can be used to identify tops, bottoms and shifts in momentum.

If the Bollinger Bands confirm a signal observed in one or more other tools, the likelihood of that signal being true is greater. The other articles in this series will highlight some of the other tools used in technical analysis by traders.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

David Frost