What are Bollinger Bands and How to Use Them?

Analysing volatility in the market is one of the primary challenges traders face in the beginning. It is always crucial for a trader to understand when a market stays calm or breaks out. In this situation, technical analysis tools like Bollinger Bands can help you identify them.

Developed by John Bollinger in 1980, the Bollinger bands indicator helps you identify potential trading opportunities with three lines. Let us understand what is Bollinger bands and how to use them.

What are Bollinger Bands in Trading?

Bollinger Bands is a technical analysis tool that takes the shape of two standard deviation lines and a moving average line. Under this moving average line, you can see the standard deviation lines plotted.

You can see the moving average line is set at 20 periods, but you can adjust it based on your preference. On the other hand, the standard deviation lines are set at two standard deviations from the moving average line. Along with market volatility, the Bollinger Bands also help you to identify the potential price range of a security.

How Traders Can Use the Bollinger Bands Indicator?

You can use Bollinger Bands to assess price volatility and price reversals of an asset. When you see the bands tighten during low volatility, this means the likelihood of a sharp price move in either direction has been increased. This is the start of a trending move.

As a trader, you have to seek a false move that reverses before the actual trend starts.  Volatility rises, and any current trend may be coming to an end when the bands diverge by an abnormally large amount. Prices tend to fluctuate within the bands’ envelope, touching one band before shifting to another.

These fluctuations can be used to determine possible profit targets. For instance, the upper band becomes the profit target if a price crosses above the moving average after bouncing off the lower band.

Example of Bollinger Bands

Suppose you are evaluating a stock price over 20 days. You can use a 20-day SMA as the middle line and keep the upper and lower bands 2 standard deviations away from the SMA.

If the price is trading within the upper and lower bands, this means there is no extreme market volatility. If the price goes outside of the upper or lower bands, then it shows that the market is highly volatile. This helps to identify potential buy or sell signals.

Calculation of the Bollinger Bands Indicator

The calculation of Bollinger Bands is quite simple. First, you need to calculate the simple moving average (SMA). Next, calculate the standard deviation over the same periods as the SMA. For the upper band, you need to add the standard deviation to the moving average. However, you must subtract the standard deviation from the moving average for the lower band. Here are the typical values that are used in the calculation:

1. Short-Term

   It is a 10-day moving average, which bands at 1.5 standard deviations.

2. Medium Term

   It is a 20-day moving average, which bands at 2 standard deviations.

3. Long-Term

   It includes a 50-day moving average that bands at 2.5 standard deviations.

How You Can Interpret the Bollinger Bands Indicator?

Bollinger Bands are an effective tool to identify trading opportunities and market volatility. Below is an explanation of how you can interpret the Bollinger Bands indicator to identify these outcomes:

Market Volatility

If the bands are narrow, this may indicate that the market is going through low volatility. On the other hand, if they are wide, it suggests that the market is highly volatile. This is useful for you in adjusting your trading strategies accordingly.

Trading Signals

You can also identify the buying or selling signals using Bollinger Bands. If an asset’s price reaches or crosses the upper band, it indicates that the asset is overbought, which generates a sell signal. On the other hand, if the price touches or goes beyond the lower band, this indicates that the asset is oversold, and it generates a buying signal.

Although Bollinger Bands help you identify key insights about trading, you should not solely rely on this indicator to make trading decisions. You must use them with other technical indicators and analytical tools to confirm signals and make effective trading decisions.

Limitations of Using the Bollinger Bands Indicator

False Signals

Bollinger Bands can show false signals, especially when there is low volatility, and the price moves sideways. You must be extra cautious and seek confirmation from other indicators.

Not a Standalone Indicator

You should not use the Band Bollinger indicator in isolation for trading decisions. They are most effective when you use them with other technical indicators and analysis tools, which minimises false signals.

Volatility

Bollinger Bands make assumptions that price movements follow a normal distribution. However, in reality, markets may exhibit non-normal distributions that can lead to inaccurate readings.

Market Dependency

Bollinger Bands work in sideways markets. However, it may become less useful in strongly trending markets, since prices may remain near the upper or lower bands.

Backward-Looking

Bollinger Bands work depending on historical data. Since they do not consider news events or any fundamental analysis, it can have a significant impact on prices.

Final Thought

Bollinger Bands help you to identify potential trend reversals, breakouts and market volatility. However, you must also be aware of the misconceptions about Bollinger Bands and simultaneously use other indicators to confirm trading decisions.

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Frequently Asked Questions

1. What do Bollinger Bands indicate?

Bollinger Bands give you an idea of market movement based on prices. When prices move close towards the upper band, it might signal the overbought conditions of the market. Contrarily, when prices stop moving closer to the lower band, it signals the oversold conditions of the market.

2. What is the success rate of the Bollinger bands indicator?

Like any other, the success rate of Bollinger Bands is not fixed and varies depending on your skills, traded assets, and market conditions. Bollinger Bands’ success depends on your ability to read them effectively.

3. Can you solely rely on Bollinger Bands for trading decisions?

No, you must not use Bollinger Bands solely and rely on them as an indicator to execute trading decisions. You must use this tool with other indicators and analytical tools.

4. How do Bollinger bands work?

Bollinger Bands work differently depending on the position of the price. If it is within the bands, then it is in the normal trading range. Additionally, when it moves close to or reaches the upper band, it may show overbought conditions.

However, when the price goes towards or touches the lower band, it may show oversold conditions, which indicates a bounce.