Bollinger Bands, invented by John Bollinger in the 1980s, help traders decide when to trade and spot overbought or oversold stocks.
Using only Bollinger Bands for trading is risky because it looks at price and volatility but ignores important details. These bands are popular but straightforward tools for traders.
In this article, we will discuss the concept behind Bollinger Bands, its calculation, interpretation, limitations, and the effectiveness of this technical analysis tool.
What are Bollinger Bands
Bollinger bands are price envelopes plotted at a standard deviation level above and below a simple moving average. A price envelope defines upper and lower price range levels. The distance in the bands is based on standard deviation. This distance adjusts to changes in the underlying price.
How this indicator works
Bollinger Bands helps traders assess price volatility and potential price reversals. They consist of three bands: the middle band, the upper band, and the lower band. Here's how Bollinger Bands work:
- Middle band: This is typically a simple moving average (SMA) of the asset's price over a specified period. The most common period used is 20 days.
- Upper band: This is calculated by adding a specified number of standard deviations to the middle band. The standard deviation measures the asset's price volatility. Commonly, two standard deviations are added to the middle band.
- Lower band: Similar to the upper band, it is calculated by subtracting a specified number of standard deviations from the middle band.
What do Bollinger bands tell you?
When the price moves closer to the upper band, Bollinger bands suggest the asset is overbought, and a reversal may be imminent. Conversely, when the price moves closer to the lower band, it suggests the asset is oversold, and a reversal to the upside may occur.
Additional read: What is Dow Theory
What do Bollinger Bands tell you?
Bollinger bands primarily indicate the level of market volatility and trading opportunities. Narrow bands indicate low market volatility, while wide bands suggest high market volatility. Bollinger bands indicators can be used by traders to assess potential buy or sell signals. For instance, a sell signal may be interpreted or generated if the asset’s price moves closer or crosses the upper band, as it may indicate that the asset is overbought. Alternatively, a buy signal may be interpreted or generated if the price moves closer to the lower band, as it may signify that the asset is oversold.
However, traders should be cautious when using Bollinger Bands as standalone indicators when making trading decisions. Experienced traders refrain from confirming signals based on one indicator. Instead, they generally combine various technical indicators and fundamental analysis methods to make informed trading decisions. Basing trading decisions on only one indicator can result in misinterpretation of signals and heavy losses.
Calculation
One of the many aspects of using Bollinger Bands in trading is understanding how to calculate them. There is a simple formula used to calculate Bollinger Bands.
Bollinger Middle Band = 20-day simple moving average (SMA)
Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
Lower Band = 20-day SMA - (20-day standard deviation of price x 2)
Example
Let's consider a trader who is examining the price movement of a well-known stock over a period of 20 days. In this scenario, the trader employs a 20-day Simple Moving Average (SMA) as the middle line and positions the upper and lower bands at a distance of two standard deviations from the SMA.
Volatility assessment: As they observe the Bollinger Bands, they notice that the bands have been relatively narrow over the past few weeks. This suggests that stock has been in a period of low volatility, with prices trading within the bands.
Bollinger squeeze: The trader recognizes that the narrowing of the bands indicates a "Bollinger Squeeze," which typically precedes a significant price move. This narrowing suggests that a breakout or breakdown in stock's price might be imminent.
Trading decision: Given the potential for a breakout, the trader decides to closely monitor the price action. They also use other technical analysis tools, such as RSI (Relative Strength Index) and MACD (Moving Average Convergence Divergence), to confirm potential signals.
Signal confirmation: A few days later, stock's price breaks out above the upper Bollinger Band with strong volume and confirms the bullish signal. Additionally, the RSI and MACD indicators also show bullish momentum.
Trade execution: Based on these confirmations, the trader decides to enter a long position in the stock, anticipating a price rally.
This example illustrates how Bollinger Bands can help traders identify potential breakout opportunities in a stock market with low volatility. However, it is crucial to emphasize that Bollinger Bands should be used in conjunction with other indicators and analysis techniques to make informed trading decisions and mitigate risks. Traders should always have a well-defined trading strategy and risk management plan in place.
Limitations Of Bollinger bands
- Not a standalone indicator: Bollinger Bands should not be used in isolation for trading decisions. They are most effective when used in conjunction with other technical indicators and analysis techniques to confirm signals and reduce false alarms.
- False signals: Bollinger Bands can produce false signals, especially during periods of low volatility when the price moves sideways. Traders need to exercise caution and look for confirmation from other indicators.
- Market condition dependency: Bollinger Bands work best in ranging or sideways markets. In strongly trending markets, prices may remain consistently near the upper or lower bands, making the indicator less useful.
- Volatility assumption: Bollinger Bands assume that price movements follow a normal distribution. In reality, markets can exhibit non-normal or fat-tailed distributions, which can lead to inaccurate readings.
- Backward-looking: Bollinger Bands are purely based on historical data. They don't take into account external factors, news events, or fundamental analysis, which can have a significant impact on prices.
Bollinger Bands are a valuable tool for assessing price volatility and potential reversals, but they have limitations. Traders should use them judiciously and be aware of their shortcomings to make more informed trading decisions.
Which indicators work best with Bollinger bands
Bollinger bands are primarily used to assess price volatility and potential price reversals. Here are some indicators that work well in combination with Bollinger Bands:
- Relative strength index (RSI): RSI is a momentum oscillator that can help identify overbought or oversold conditions when used in conjunction with Bollinger bands. A divergence between RSI and the price within the Bollinger Bands can signal a potential reversal.
- Moving averages: Simple and exponential moving averages can be used with Bollinger bands to identify trends and confirm potential trend changes. When the price moves above the upper Bollinger band and is supported by a moving average crossover (e.g., the 50-day moving average crossing above the 200-day moving average), it can signal a strong bullish trend.
- MACD (Moving average convergence divergence): MACD can be used to identify momentum and potential trend reversals in conjunction with Bollinger bands. Crossovers of the MACD line and the signal line, along with their positions relative to the Bollinger bands, can provide valuable buy or sell signals.
- Stochastic oscillator: The Stochastic Oscillator can help confirm overbought or oversold conditions when combined with Bollinger bands. Divergences or crossovers in the stochastic lines within the Bollinger bands may indicate potential turning points.
- Volume indicators: Volume indicators like the On-balance volume (OBV) can be useful when combined with Bollinger bands to gauge the strength of price movements. Increased volume near the upper or lower bands can signal potential reversals.
- Fibonacci retracement levels: Fibonacci retracement levels can help identify potential support and resistance levels within the Bollinger bands. Traders often look for confluence between these levels and Bollinger bands to make trading decisions.
Remember that the effectiveness of these indicators in combination with Bollinger bands depends on the specific market conditions and the trader's strategy. It's essential to backtest and practice using these indicators to develop a reliable trading approach.
How accurate are Bollinger bands
The accuracy of Bollinger Bands as a technical analysis tool for traders evaluating price data cannot be measured without considering various factors.
Traders using Bollinger Bands alongside other technical analysis tools, including trendlines, candlestick charts, and Relative Strength Index (RSI), and fundamental analysis tools, which include analysing a company's financial statement, can improve the accuracy of trading signals.
In essence, Bollinger Bands' accuracy will vary on a case-by-case basis, and traders must constantly adapt and adjust their strategies to changing market conditions and financial instrument prices. Nevertheless, Bollinger Bands can be relatively accurate in generating signals to enter or exit a trade, and traders can increase its accuracy by using it in conjunction with other technical analysis and fundamental analysis tools.
Conclusion
In conclusion, Bollinger Bands are a valuable tool for stock market analysis. These dynamic bands provide insights into price volatility, potential overbought or oversold conditions, and can even signal impending breakouts.
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