Finding the right technical indicator for a strategy is always a tedious task. With options like moving averages, RSI (relative strength index), MACD (moving average convergence divergence), and others being easily available, it is difficult to choose which one would work for you. If you are starting your trading journey and don’t know where to start, then let me introduce a beginner-friendly and flexible technical indicator: the Bollinger Bands®.
What are Bollinger Bands®?
Bollinger Bands® are price envelopes developed by John Bollinger that uses 2 standard deviations and a moving average of an instrument to create a band around the price of an asset. Its upper band represents two standard deviations above the moving average and the lower band represents two standard deviations below the moving average. The volatility of the asset is used to determine the distance between the upper and lower bands. The closer the bands are to the moving average, the lower the volatility, while wider bands indicate higher volatility.
How to calculate Bollinger Bands®?
To calculate Bollinger Bands, you will need to first get the simple moving average (SMA) of the security. Let’s say, a 20-day SMA. A 20-day SMA averages the closing prices of the instrument for the last 20 days. Next, you will need to get the Standard Deviation of the instrument. Standard deviation is a mathematical measurement of average variance and is mostly found in statistics, economics, accounting, and finance.
The standard deviation measures how far 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.
Then, you 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.
The formula is shown below.
The good thing about charting sites like TradingView is that you can just add the Bollinger Bands® and use them right away without doing calculations.
How do Bollinger Bands® work?
Bollinger Bands work by providing traders with a visual indication of the volatility of security that envelops its moving average. When the band shows that they are close to the moving average, it indicates that the security is currently experiencing low volatility and is contracting. Conversely, when the bands are wide or expanding it indicates that the asset is experiencing a rise in volatility.
Investors and traders using Bollinger Bands can use this to identify periods of consolidation and breakouts. Consolidation occurs when the security’s price moves within a narrow range and the bands are close together, indicating low volatility. Breakouts occur when an asset’s price moves outside of the consolidation range. During breakouts, the bands will start to widen, expansion of volatility.
Bollinger Bands® can also be used to identify potential trend reversals. When an asset’s price moves from the lower band to the upper band, it indicates that the asset may be oversold, and a trend reversal may occur. Now when an asset’s price moves from the upper band to the lower band, the price may be oversold.
How to use Bollinger Bands® in trading
Traders and investors can use Bollinger Bands® in their strategy in different ways. It can be used for trend-following strategies, reversal signals, breakouts, and many more. Let’s take a look at these sample applications of Bollinger Bands®.
Buying into a trending stock
Investors can use Bollinger Bands® to buy into trending stocks. For example, when a stock is bullish and trending, traders and investors can find pockets of opportunities in times when price and Bollinger Bands ® show contractions on the volatility and a pattern consolidation. When prices jump or start trading on the upper band,
Finding potential breakouts
Investors and Traders can use the indicator to spot potential breakouts using the contractions of volatility. When combined with other analyses, the indicator can complement existing strategies. For example, if the bands’ contract and price consolidate and then starts moving onto the upper band whiles starting to show expansion of the band indicates a high potential breakout is underway.
Using Bollinger Bands® as buy and sell signals
Traders can also use Bollinger Bands® to identify potential buy and sell signals. When an asset’s price moves to the lower band, it may indicate that the asset is oversold, and a buy signal may be generated once the price bounces back and crosses the moving average. Conversely, when an asset’s price moves to the upper band, it may indicate that the asset is overbought, and a sell signal can be generated.
Limitations of Bollinger Bands®
Like all technical analysis tools, Bollinger Bands® has limitations. For one, it shouldn’t be used in isolation. It is highly suggested that investors and traders use it with other technical analysis tools and fundamental analysis to supplement their strategy. Additionally, Bollinger Bands® are based on past price data, which is not a predictor of future price movements. Investors should always test strategies that use the indicator to understand the risk and expectancy of the indicator’s performance.
Like every other technical indicator, it is important to note that Bollinger Bands® are not foolproof. While it prides itself on identifying potential breakouts and trend reversals, there is always a risk of false signals. Traders and investors should always use risk management techniques, such as stop-loss orders, to limit their losses in case a trade goes against them.
Adding Bollinger Bands® to a strategy can provide additional insights into understanding volatility and price movements as well as finding opportunities to enter a reverse of the trend, buy into a breakout, and others. However, due diligence and backtesting are a must to have realistic expectations of the performance of the indicator. This will provide any investor with a way to assess and adjust its applications to suit their trading strategy and goals.