What are Bollinger Bands?
Bollinger Bands are volatility bands usually plotted two standard deviations above and below a moving average. They were developed by John Bollinger who owns the trademark Bollinger Band®. Simply put, they are used as reliable determinants of the volatility of securities. That is because they have the ability to automatically narrow when volatility decreases and widen when it increases. Their dynamic nature makes them great determinants of the strength of a trend. Furthermore, they are very reliable when it comes to identifying W-Bottoms and M-Tops.
How Bollinger Bands Are Calculated
Bollinger Bands are three separate lines. That means to determine them you need to perform three very simple calculations. Each one is summarized below. Please note that you should start by determining the standard deviation because you will need the value.
Middle band (first line): calculate the simple moving average for a 20-period duration (like 20 days). Use closing prices of the security in question.
Upper band (second line): add two standard deviations to the middle band; i.e. middle band + 2 standard deviations.
Lower band (third line): subtract two standard deviations from the middle band; i.e. middle band – 2 standard deviations.
What Bollinger Bands Indicate
Bollinger Bands form a very powerful trading indicator. As a matter of fact, you can use them solely to develop your trading strategy if other indicators are not clear. That is because they are drawn from the price structure of a security and provide reliable boundaries of lows and highs. The middle band is a powerful trend indicator of the stock because it analyzes the 20-period moving average. On the other hand, the upper and lower bands measure volatility. More often than not, when the bands tighten it always means that volatility is set to increase sharply. In more particular terms, when prices move closer to the upper band it means that the security is being overbought. On the other hand, when prices move closer to the lower band it always means that they are being oversold.
Using Bollinger Bands for Trading
Bollinger Bands can help you achieve consistent trading success when you use them properly and accurately. This section contains tips on how you can use the bands to achieve success, but first, it is important to mention that the price of a stock is relatively high if it is close to the upper band but relatively low if it is close to the lower band.
* Buy and sell signals: when the stock price surpasses the upper band, it generates a buy signal. Contrary to that, when it goes below the lower band then that is a sell signal. Of course, buy and sell signals are important because they ultimately determine whether your security will make a profit or not.
* Volatility measure: when Bollinger Bands narrow (move closer to each other), that is an indication of decreasing volatility. However, when they widen it means that there is an increase in volatility. In case you don’t know yet, high volatility means that the security is very risky.
* Trend-trading: Bollinger Bands are not static indicators and thus change depending on recent price dynamics. That makes them great tools for measuring not only volatility but momentum as well. Usually, when prices stay close to the upper band, it means that the security is recording a strong (consistent) trend. When prices pull away from outer bands then that is an indication that the momentum is fading. Another way of determining fading momentum is using the “three pushes to high” technique. As the name suggests, it develops from three pushes. The first one will record a new high, usually outside the upper band. The second will record a new high and touch the upper band. The final push will record a new high but will remain within the upper band. Such an observation is a reliable indicator of fading momentum.
* Combined with RSI: another way to use Bollinger Bands in trading involves applying them around another indicator – the Relative Strength Index (RSI). In this case, you need to observe for when RSI is tending towards an extreme high or low (usually towards 100 or 0 respectively). If it progresses and eventually touches the upper band but fails to do so on a second try then that is a sell signal. On the same note, if it touches the lower band but fails to touch it again on a second try then you have a buy signal.
What we have here are just a few tips that you can incorporate into your trading strategy. As you continue to use Bollinger Bands, you will realize that they offer much more than we can possibly cover. However, the information you have acquired is sufficient to get you started.