Bollinger Bands
Bollinger Bands are a technical analysis tool developed by John Bollinger that consists of a middle band (simple moving average) with an upper and lower band that are standard deviations away from the middle band. The bands expand and contract based on volatility, helping traders identify potential overbought and oversold conditions, as well as trend strength and direction.
Formula
Middle Band = 20-day Simple Moving Average (SMA)
Upper Band = Middle Band + (2 × Standard Deviation)
Lower Band = Middle Band - (2 × Standard Deviation)
Where Standard Deviation is calculated over the same period as the SMA
How Bollinger Bands Work
Bollinger Bands adapt dynamically to market conditions by widening during volatile periods and narrowing during less volatile periods. The bands create an envelope around the price, with roughly 90% of price action occurring between the bands. When prices move close to the upper band, it may indicate overbought conditions, while prices near the lower band may suggest oversold conditions. A period of band contraction (known as the squeeze) often precedes significant price movements.
Trading Strategies Using Bollinger Bands
Strategy Examples
- Trade bounces off the bands in ranging markets
- Look for breakouts when bands squeeze together
- Use band touches as exit points for trades
- Identify trend strength through band width
- Watch for price action outside the bands for potential reversals
Support and Resistance Strategy
- Use bands as dynamic support and resistance levels
- Look for price bounces off the bands at key levels
- Monitor band width at major support/resistance zones
- Use band touches with price action for confirmation
- Combine with traditional support/resistance for stronger signals
Trend Identification
- Price riding upper band indicates strong uptrend
- Price riding lower band indicates strong downtrend
- Price crossing middle band suggests trend changes
- Band width expansion shows trend strength
- Band width contraction warns of trend exhaustion
Advantages and Limitations
Advantages
- Adapts automatically to market volatility
- Provides clear overbought/oversold signals
- Helps identify potential trend reversals
- Works across different markets and timeframes
- Combines trend and volatility analysis
Limitations
- Can give false signals in strong trends
- Lag due to moving average calculations
- Requires additional confirmation indicators
- May not work well in non-normal distributions
- Band touches don't always indicate reversals
Best Practices When Using Bollinger Bands
- Combine Bollinger Band signals with other technical indicators for confirmation
- Use multiple timeframes to validate trend direction and strength
- Wait for price to close beyond the bands rather than just touch them
- Consider market volatility when interpreting band width changes
- Monitor volume alongside price movements relative to the bands
- Look for divergences between price action and band movements
- Use appropriate standard deviation settings based on market conditions
- Be cautious of false signals during major news events or high volatility
- Implement proper risk management with clear stop-loss levels
- Consider using Bollinger Band %B and Bandwidth indicators for additional insight