Bollinger Bands are a trend indicator developed in the 1980s. They take a simple moving average (SMA) and track a standard deviation away from that average on either side. On a graph, this manifests as three lines: a simple moving average (SMA), an upper band, and a lower band.
To understand why Bollinger Bands are such a powerful trading tool, let’s take a closer look at what each of those bands represents.
Understanding Bollinger Bands
A simple moving average is a popular trend-following indicator that tracks the mean closing price of a stock or commodity over time to gauge the overall strength and direction of the trend. Moving averages play an integral role in most trading strategies, both as basic trend-following indicators and as building blocks for trend-confirming tools like the Moving Average Convergence/Divergence (MACD). So why fix something that’s not broken and introduce a standard deviation calculation?
Standard deviation is used to determine variance, or how much a given dataset fluctuates from its mean. In the figure above, the upper band reflects the SMA plus one standard deviation, and the lower band shows the SMA minus one standard deviation. This is exceptionally important to forex traders because two currency pairs that have the same SMA may have different standard deviations. In such an instance, both currency pairs would reveal the same market trend but represent very different risk levels. Take the two datasets below as an example.
Currency Pair A: 10, 11, 16, 12, 13
Currency Pair B: 4, 18, 2, 25, 13
Imagine that the five values in each set represent the SMA for closing price over a period of five days. Both datasets span a five-day period and have the same sum total of 62, so the SMA (mean) for both sets would equal 12.4. With an identical SMA, both graphs would show the same directional trend. But look closely at each dataset, and you’ll notice that closing prices for Pair A are significantly more varied from the mean, with prices dropping as low as 4 and rising as high as 25 in a short range. The standard deviation values for Pair A and Pair B are as follows:
Currency Pair A: 2.33
Currency Pair B: 3.43
Pair B’s standard deviation value reflects a higher degree of variance (i.e., a wider range of closing prices). By adding a simple standard deviation calculation to a SMA, John Bollinger thereby created a volatility indicator capable of responding to market conditions. Because Bollinger Bands take variance into account, the high and low price range bracketed by the upper and lower bands presents a more accurate price scope than the SMA alone can provide.
As you might have guessed, Bollinger Bands will widen during periods of high volatility and constrict during low-volatility periods when the standard deviation is relatively low. In the figure below, the bands are widest at point A, indicative of high market volatility around May 23. Bandwidth then tightens significantly moving into May 24, suggesting a period of greater stability. The short bandwidth captured at point B shows that the market remained relatively stable on May 24 before becoming steadily more volatile approaching Point C on May 25.
Locating Trading Opportunities and Assessing Relative Risk
To use Bollinger Bands to the fullest, traders look at price candlestick movements in relation to the SMA and upper and lower bands. When prices touch the upper band, the stock or commodity in question is said to be “overbought,” a common sell signal.
When the opposite is true—when prices consistently touch the lower band—the stock or commodity is thought to be “oversold,” producing a buy signal.
During a strong downtrend, prices can move between the lower band and the SMA. Conversely, in a strong uptrend, prices will move between the upper band and the SMA. If price crosses over the SMA in either instance, it’s usually indicative of a trend reversal. In the image below, you can see that price continues in a strong uptrend (fluctuating between the SMA and upper band) before finally crossing over the SMA and reversing to the downside.
Reading the trend and anticipating whether it will continue or reverse is key to a profitable investment strategy. Reversals are inherently difficult to forecast and should not be acted upon without gaining additional confirmation. Notice in the first part of the above chart how price touches the SMA early on before continuing in a strong downtrend. If a trader were to preemptively interpret this “touch” as a precursor to a reversal, he or she would invest against the trend and ultimately forfeit profits. When identifying reversals, it’s more effective to wait for price to cross over the SMA and continue in the anticipated direction.
The “squeeze” refers to a Bollinger Band pattern in which standard deviation reaches a six-month low. As you might expect, the squeeze manifests as a tightening of the bands in a more parallel fashion. Bollinger created his famous band formula under the premise that price will constantly fluctuate between periods of high and low volatility. He therefore views the squeeze as a product of previous volatility and precursor to future volatility. Because it represents a profound and prolonged period of low volatility, the squeeze is often thought to signal a breakout. But what direction will that breakout take?
To determine the direction of the breakout, it’s necessary to consult other indicators. Momentum indicators like the relative strength index (RSI) and Stochastic Oscillators can help identify if the divergence is likely to be positive or negative. Within the context of these indicators, a positive divergence is considered a bullish signal, and a negative divergence is considered bearish. To be safe, consult a variety of tools, and hold off on choosing an investment strategy until you have substantial trend confirmation. “Head fakes”—when a trend initiates in one direction only to reverse and continue on the opposite course—frequently occur after a squeeze and can punish investors who act too quickly. When it comes to investing with the trend, a certain degree of patience and prudence is more lucrative than celerity.
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