Bollinger Bands, Volatility And You

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Bollinger Bands® are a type of chart indicator for technical analysis and have become widely used by traders in many markets, including stocks, futures, and currencies. Created by John Bollinger in the 1980s, the bands offer unique insights into price and volatility. In fact, there are a number of uses for Bollinger Bands®, such as determining overbought and oversold levels, as a trend following tool, and for monitoring for breakouts.

Key Takeaways

  • Bollinger Bands® are a trading tool used to determine entry and exit points for a trade.
  • The bands are often used to determine overbought and oversold conditions.
  • Using only the bands to trade is a risky strategy since the indicator focuses on price and volatility, while ignoring a lot of other relevant information.
  • Bollinger Bands® are a rather simple trading tool, and are incredibly popular with both professional and at-home traders.

Calculation of Bollinger Bands

Bollinger Bands® are composed of three lines. One of the more common calculations uses a 20-day simple moving average (SMA) for the middle band. The upper band is calculated by taking the middle band and adding twice the daily standard deviation to that amount. The lower band is calculated by taking the middle band minus two times the daily standard deviation.

The Bollinger Band® formula consists of the following:

Overbought and Oversold Strategy

A common approach when using Bollinger Bands® is to identify overbought or oversold market conditions. When the price of the asset breaks below the lower band of the Bollinger Bands®, prices have perhaps fallen too much and are due to bounce. On the other hand, when price breaks above the upper band, the market is perhaps overbought and due for a pullback.

Using the bands as overbought/oversold indicators relies on the concept of mean reversion of the price. Mean reversion assumes that, if the price deviates substantially from the mean or average, it eventually reverts back to the mean price.

Bollinger Bands® identify asset prices that have deviated from the mean.

In range-bound markets, mean reversion strategies can work well, as prices travel between the two bands like a bouncing ball. However, Bollinger Bands® don’t always give accurate buy and sell signals. During a strong trend, for example, the trader runs the risk of placing trades on the wrong side of the move because the indicator can flash overbought or oversold signals too soon.

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To help remedy this, a trader can look at the overall direction of price and then only take trade signals that align the trader with the trend. For example, if the trend is down, only take short positions when the upper band is tagged. The lower band can still be used as an exit if desired, but a new long position is not opened since that would mean going against the trend.

Create Multiple Bands for Greater Insight

As John Bollinger acknowledged, “tags of the bands are just that, tags, not signals.” A tag (or touch) of the upper Bollinger Band® is not in and of itself a sell signal. A tag of the lower Bollinger Band® is not in and of itself a buy signal. Price often can and does “walk the band.” In those markets, traders who continuously try to “sell the top” or “buy the bottom” are faced with an excruciating series of stop-outs, or even worse, ever-mounting losses as price moves further and further away from the original entry.

Perhaps a more useful way to trade with Bollinger Bands® is to use them to gauge trends.

At the core, Bollinger Bands® measure deviation, which is why the indicator can be very helpful in diagnosing trend. By generating two sets of Bollinger Bands®, one set using the parameter of “one standard deviation” and the other using the typical setting of “two standard deviations,” we can look at price in a whole new way. We will call this Bollinger Band® “bands.”

In the chart below, for example, we see that whenever price holds between the upper Bollinger Bands® +1 SD and +2 SD away from mean, the trend is up; therefore, we can define that channel as the “buy zone.” Conversely, if price channels within Bollinger Bands® –1 SD and –2 SD, it is in the “sell zone.” Finally, if price meanders between +1 SD band and –1 SD band, it is essentially in a neutral state, and we can say that it’s in “no man’s land.”

Bollinger Bands® adapt dynamically to price expanding and contracting as volatility increases and decreases. Therefore, the bands naturally widen and narrow in sync with price action, creating a very accurate trending envelope.

A Tool for Trend Traders and Faders

Having established the basic rules for Bollinger Band® “bands,” we can now demonstrate how this technical tool can be used by both trend traders who seek to exploit momentum and fade-traders who like to profit from trend exhaustion or reversals. Returning to the chart above, we can see how trend traders would position long once price entered the “buy zone.” They would then be able to stay in the trade as the Bollinger Band® “bands” encapsulate most of the price action of the move higher.

As for an exit point, the answer is different for each individual trader, but one reasonable possibility would be to close a long trade if the candle on the candlestick charts turn red and more than 75% of its body were below the “buy zone.” Using the 75% rule, at that point, price clearly falls out of trend, but why insist that the candle be red? The reason for the second condition is to prevent the trend trader from being “wiggled out” of a trend by a quick move to the downside that snaps back to the “buy zone” at the end of the trading period.

Note how, in the following chart, the trader is able to stay with the move for most of the uptrend, exiting only when price starts to consolidate at the top of the new range.

Bollinger Band® “bands” can also be a valuable tool for traders who like to exploit trend exhaustion by helping to identify the turn in price. Note, however, that counter-trend trading requires far larger margins of error, as trends will often make several attempts at continuation before reversing.

In the chart below, we see that a fade-trader using Bollinger Band® “bands” will be able to quickly diagnose the first hint of trend weakness. Having seen prices fall out of the trend channel, the fader may decide to make classic use of Bollinger Bands® by shorting the next tag of the upper Bollinger Band®.

As for the stop-loss points, putting the stop just above the swing high will practically assure the trader is stopped out, as the price will often make many forays at the recent top as buyers try to extend the trend. Instead, it is sometimes wise to measure the width of the “no man’s land” area (distance between +1 and –1 SD) and add it to the upper band. By using the volatility of the market to help set a stop-loss level, the trader avoids getting stopped out and is able to remain in the short trade once the price starts declining.

Bollinger Bands Squeeze Strategy

Another strategy to use with Bollinger Bands® is called a squeeze strategy. A squeeze occurs when the price has been moving aggressively then starts moving sideways in a tight consolidation.

A trader can visually identify when the price of an asset is consolidating because the upper and lower bands get closer together. This means the volatility of the asset has decreased. After a period of consolidation, the price often makes a larger move in either direction, ideally on high volume. Expanding volume on a breakout is a sign that traders are voting with their money that the price will continue to move in the breakout direction.

When the price breaks through the upper or lower band, the trader buys or sells the asset, respectively. A stop-loss order is traditionally placed outside the consolidation on the opposite side of the breakout.

Bollinger vs. Keltner

Bollinger Bands® and Keltner Channels are different, but similar, indicators. Here is a brief look at the differences, so you can decide which one you like better.

Bollinger Bands® use standard deviation of the underlying asset, while Keltner Channels use the average true range (ATR), which is a measure of volatility based on the range of trading in the security. Aside from how the bands/channels are created, the interpretation of these indicators is generally the same.

One technical indicator is not better than the other; it is a personal choice based on which works best for the strategies being employed.

Since Keltner Channels use average true range rather than standard deviation, it is common to see more buy and sell signals generated in Keltner Channels than when using Bollinger Bands®.

The Bottom Line

There are multiple uses for Bollinger Bands®, including using them for overbought and oversold trade signals. Traders can also add multiple bands, which helps highlight the strength of price moves. Another way to use the bands is to look for volatility contractions. These contractions are typically followed by significant price breakouts, ideally on large volume. Bollinger Bands® should not be confused with Keltner Channels. While the two indicators are similar, they are not exactly alike.

Bollinger Band® Definition

What Is a Bollinger Band®?

A Bollinger Band® is a technical analysis tool defined by a set of lines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of the security’s price, but can be adjusted to user preferences. Bollinger Bands® were developed and copyrighted by famous technical trader John Bollinger,

In the chart depicted below, Bollinger Bands® bracket the 20-day SMA of the stock with an upper and lower band along with the daily movements of the stock’s price. Because standard deviation is a measure of volatility, when the markets become more volatile the bands widen; during less volatile periods, the bands contract.

Key Takeaways

  • Bollinger Bands® are a technical analysis tool developed by John Bollinger.
  • There are three lines that compose Bollinger Bands: A simple moving average (middle band) and an upper and lower band.
  • The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average, but can be modified.

Understanding Bollinger Bands

How To Calculate Bollinger Bands®

The first step in calculating Bollinger Bands® is to compute the simple moving average of the security in question, typically using a 20-day SMA. A 20-day moving average would average out the closing prices for the first 20 days as the first data point. The next data point would drop the earliest price, add the price on day 21 and take the average, and so on. Next, the standard deviation of the security’s price will be obtained. Standard deviation is a mathematical measurement of average variance and features prominently in statistics, economics, accounting and finance. For a given data set, the standard deviation measures how spread out numbers are from an average value. Standard deviation can be calculated by taking the square root of the variance, which itself is the average of the squared differences of the mean. Next, multiply that standard deviation value by two and both add and subtract that amount from each point along the SMA. Those produce the upper and lower bands.

Here is this Bollinger Band® formula:

What Do Bollinger Bands® Tell You?

Bollinger Bands® are a highly popular technique. Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. John Bollinger has a set of 22 rules to follow when using the bands as a trading system.

The Squeeze

The squeeze is the central concept of Bollinger Bands®. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities. Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or which direction price could move.

Breakouts

Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event. The breakout is not a trading signal. The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.

Limitations of Bollinger Bands®

Bollinger Bands® are not a standalone trading system. They are simply one indicator designed to provide traders with information regarding price volatility. John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals. He believes it is crucial to use indicators based on different types of data. Some of his favored technical techniques are moving average divergence/convergence (MACD), on-balance volume and relative strength index (RSI).

Because they are computed from a simple moving average, they weight older price data the same as the most recent, meaning that new information may be diluted by outdated data. Also, the use of 20-day SMA and 2 standard deviations is a bit arbitrary and may not work for everyone in every situation. Traders should adjust their SMA and standard deviation assumptions accordingly and monitor them.

The bottom line is that Bollinger Bands® are designed to discover opportunities that give investors a higher probability of success.

Bollinger Bands, Volatility And You

Bollinger Bands, Volatility And You

Bollinger Bands ™ are one of the most dynamic and versatile trading tools on the market. The indicator was created by John Bollinger in the early 1980’s and captures one of his deepest insights. The idea that volatility was not static, that it changed from day to day, a thought contrary to popular market belief at the time. The tool presents as an envelope, similar to moving average envelopes, Keltner Channels and others but is based on measures of volatility. The bands are created from a standard deviation of price movement over a set period of time, much like basic volatility indicators such as historic and relative volatility. In my opinion, this is the best tool for measuring volatility but also a great tool for binary options traders to understand. It can be used in a wide variety of ways, gives of a number of easily recognizable signals and can be used as a stand alone indicator or with a package of other tools.

The tool is intended to show when prices are high or low relative to past price action. This means that prices are considered to be “high” when at the upper band and “low” when at the lower band. The indicator includes a total of three lines. The first is the central signal line, usually a simple moving average that is typically set to a period of 20. The same data used for the center line is then used to create the other two bands, the Bollinger Bands ™. These are a standard deviation of the central line, usually 2 but it, like the moving average itself, can be adjusted to your liking. Because the bands are based on a standard deviation of price movement they are highly sensitive to volatility in the market and change on a day to day basis as the mood of the market changes. The bands will expand when volatility is high and contract when volatility is low. Signals can be given when prices reach, cross or exceed any of the three bands or when the bands expand and contract, or a combination of the two. The thing to remember is that these signals are not tied to trend. The best use is as I have mentioned above, alongside other indicators, but here I will go over some of the basic signals that binary traders can use.

Simple And Profitable Bollinger Band Signals ™

The most signal is the simple expansion and contraction of the bands themselves. This represents increases and decreases in market volatility. When compared to price action and other indicators these swings can be powerful confirming indicators. For example, the bands have narrowed and the market trended in a tight sideways range and then the bands begin to widen. The widening of the bands means that volatility is beginning to creep into the market, suggesting a stronger move than “normal”. Your complimentary analysis tells you the market is about to sell off so you can assume that the move will be to the downside. Additionally, if the market has been trending and the bands are very wide, then begin to contract, you can assume that the trend is cooling off and then look for entries to suit.

You can also use the bands themselves to give signals. The rules for this vary from trader to trader and style to style, a sign of how adaptable the tool is. The following rules are more like suggestions and should be applied carefully when you first begin to use them with your strategy. The first is that when the bands widen following a period of contraction and price moves to touch either band it is often an indication of direction. There may be a pullback following the first touch but so long as prices do not overly exceed the bands they can be expected to continue in that direction into the near term.

Another signals occurs after the bands begin to widen and volatility has picked up. Basically, the bands provide limits where the market is considered to be highly priced. Usually, when prices exceed the band on either side it signifies that market has gotten ahead of itself and prices are extremely high or extremely low and about to pull back. This signal is good for really short term entries. This signal is incredibly accurate when used with Fibonacci Retracements or other support/resistance analysis.

A third signal useful for trades is the moving average cross. Price action can be expected to move from extreme to extreme regardless of the amount of volatility in the market. As prices trend higher, lower or sideways they will approach the center moving average and give signals. This could be a crossover which means that prices are likely to continue to the opposite band or they will be reversals, and prices will move back to the band they just left.

Look at the chart above. At point 1 price move from a period of low volatility to high volatility, indicating a move is on the way. They hit the upper band but exceed it, indicating the trend is up but that prices may pull back first. At point 2 prices have pulled back, to the center signal line, where they bounced in line with the original indication at point 1. At this time prices move higher again but at point 3 again exceed the band and indicate a pull back. The next pull back was mild, but tradeable, and lead to another trend following entry. Now, at point 4 prices are brushing the upper band but not exceeding it, indicating the trend is up and strong, but not overly priced with no indication of a pull back. When prices meet resistance it fails, as indicated by the Bollinger Bands ™.

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