Bollinger Bands is a trading tool used to analyze the movement of stock prices on the market. This tool was created by John Bollinger, during the early 1980s. It consists of lines that represent standard deviations, positive, and negative relative to the simple moving average (SMA).
These lines, which deviate from the Simple Moving Average of a stock price, give traders better insight when commodities are overbought or oversold. This way, traders can determine overbought and oversold zones. So, it can be determined if the prices are relatively high or low.
Bollinger Bands has three lines plotted on the chart, and these are:
The Middle Line is a Simple Moving Average and located between the Upper Band and the Lower Band. Upper and Lower Bands represent deviations, positive, and negative from the Middle Line (SMA). Deviations of the Upper and Lower Bands from the Midline are the main components of this tool. It is an indicator of volatility, therefore, deviations from the simple moving average of the stock price. In other words, it shows how high or low is the price of goods concerning the middle line. This line (SMA) is usually set for 20 days and serves as a base for the other two lines, the base for deviations.
Here, in fact, lies the power of this tool, although it may not seem so at first glance. The stock price is high if it is on the Upper Band and low if it is on the Lower Band. In combination with other indicators, it becomes an even more powerful tool. How far the Upper and Lower Band will be from the SMA depends on price volatility. If the volatility increases, the lines are more spread, therefore further away from the SMA. If, on the other hand, volatility decreases, Upper and Lower Bands will narrow and approach SMA.
The first thing to do in the calculation is to determine a simple moving average share price, as emphasized by using a 20-day SMA. This SMA would be the average closing price for the first 20 days. That is the starting point of this data. The next data point is the earliest share price, then the price added on the 21st day, and the average is taken from that. Then so on. Then, the standard deviation of the share price was obtained.
For the data obtained, the standard deviation, which is a mathematical measurement, determines how far the lines are from the average value. In other words, how far the numbers are from the average value of the price. To obtain the exact values of the deviation, so, the standard deviation, the square root of the variance is taken. Then that value is multiplied by two and added and subtracted off the average value (SMA). Therefore, on both sides along the middle line at each point. It gives the upper and lower bands.
This is what the Bollinger Bands calculation formula looks like:
BOLU = MA(TP,n)+m∗σ[TP,n]
BOLD = MA(TP,n)−m∗σ[TP,n]
BOLU=Upper Bollinger Band
BOLD=Lower Bollinger Band
TP (typical price)=(High+Low+Close)÷3
n=Number of days in smoothing period (typically 20)
m=Number of standard deviations (typically 2)
σ[TP,n]=Standard Deviation over last n periods of TP
As already mentioned, Bollinger Bands indicate market volatility. In this way, recognize overbought and oversold zones. When prices go close to the upper band, the market is more overbought. Conversely, when prices go close to a lower band the market is more oversold. When the price enters one of the areas, either overbought or oversold, it can become an even more pronounced, stronger trend before a reversal occurs. Additional information should always be available as evidence as to whether prices will strengthen or weaken before predicting a reverse move.
Higher market volatility is when the standard deviation is higher, meaning a deviation from the midline. Then the upper and lower bands are wider, and then the market is loud. When market volatility is lower the bands are narrower, meaning they are closer to SMA, and then the market is quiet. Since the upper and lower bands measure market volatility, each time with changes in the market, the lines themselves are corrected. They adapt to the conditions.
When the bands are tight, that is, when the volatility is low, it can mean the movement of prices in any direction. It may start a new price trend. There is always the possibility of a false move in one of the directions. Then the price would change direction and go the proper trend.
Another specific case when the bands are wide is high volatility, and any trend at that point is possible to end. Prices will then most likely bounce off the band by touching it, and move within bands to another band. The concept of this is the so-called Bollinger Bounce. It means that when the price touches one of the bands, it tends to return to the middle within the bands, to the middle line. When such changes occur, meaning price fluctuations, further flows, and potential earnings can be identified or predicted. For example, if the price bounces off from one of the bands, and he crosses the middle line, the opposite band is then the target for profit.
Additional research can always be done to increase the possibility of winning predictions and gains. For example, if the price goes outside the band is to expect such a trend to continue. But if the price immediately returns within the band then the proposed expected trend is negated.
If the price touches the Upper Band and the indicator does not indicate a move up, then it is a sell signal. If a given situation indicator shows an upward movement, then it is not a sell signal, it is a buy signal. Conversely, if the price touches the Lower Band and the indicator does not show a downward trend, it is a buy signal. If the indicator shows a downward movement, it is a sell signal.
That is one of the main terms. When the bands are close to the middle line, it means when they are tight, it is called a squeeze. It is, as already said, a period of low volatility. It means that this may be a signal of potentially increased volatility and thus an opportunity for trade.
When prices start to break through tight bands, then they will keep the trend when breaking. When the price breaks the upper band then tends to keep moving up. If the price starts to break through the lower band, then it will continue to move down.
Contrary to this trend, bands can be widespread, which means high volatility. Then there is a tendency for volatility to decrease, and it announces the possibility of leaving the trade.
However, such cases are not usually signals of trade. Bands in themselves are not an indication of when changes may occur or indicate the direction of change. This strategy can be useful to notice changes and moves as early as possible and then react.
We hope you’ve learned some new today! Check out the next term in line on our stocks encyclopedia – Candlesticks.