A Bollinger Band is an indicator tool that can be used in technical analysis of financial markets. Essentially, this classic technical indicator is composed of a bounded set of lines that are positioned two standard deviations away from an asset’s 20-period simple moving average (SMA).
Of course, these specific price measurements can be adjusted to fit the requirements of each person’s unique trading style. However, these are the defined parameters which were used when John Bollinger first made these tools available to the public in the 1980s.
In the chart depicted above, Bollinger Bands can be seen bracketing a 20-period SMA on the price history. The upper Bollinger Band represents a value that is two standard deviations above the average (a positive deviation) while the lower Bollinger Band represents a value that is two standard deviations below the average (a negative deviation).
In practice, Bollinger Bands combine to create one of the most potent and reliable trading indicators in the world of technical analysis. They can be used to interpret the strength of a trend, to identify market tops or bottoms, and to time trade entries under several different market conditions. Traders shouldn’t consider this charting tool to be a “lagging” indicator because Bollinger Bands are capable of adjusting to real-time changes in price action and use market volatility to send emerging trade signals.
As a true measure of price volatility, these values change with movements in the underlying market value of the asset. In other words, when market activity becomes more volatile, the Bollinger Bands will spread farther apart. When market activity slows, the Bollinger Bands will contract.
Defined as a degree of positive or negative price variation over time, volatility is generally measured through standard deviation. In any given data set, the typical Bollinger Band standard deviation will measure the distance between current asset prices and compare that value to the average price of the asset over the previous 20 price periods.
In statistical terms, the standard deviation is calculated using the square root of all price variance in our chosen timeframe (20 closing periods). This in itself represents the average of all squared differences present in the mean. Multiply this standard deviation value by a factor of two, then add (and subtract) that value from every price point that is present on the 20-period SMA. This produces the values which define the upper and lower Bollinger Bands.
The main point to remember here is that roughly 95% of all price action is expected to occur between the upper and lower Bollinger Bands. That’s the reason Bollinger Bands are ideal for traders looking to assess the relative volatility risks involved when trading in certain assets. In essence, Bollinger Bands give us a visual representation of the price extremes likely to contain market activity related to any asset.
Remember: Since nearly all of the market’s expected price action occurs between the upper and lower Bollinger Bands, any breakout above or below the boundaries represents a major event in the market.
As a result, prices rising above the upper Bollinger Band indicate overbought markets (Sell signal). Conversely, prices falling below the lower Bollinger Band indicate oversold markets (Buy signal). These signals are strengthened when prices fail to close above/below the Bollinger Band envelope and leave a long candlewick. This represents an additional (confirming) signal indicating a potential price reversal has developed.
Next, we will look at a real-time trading situation and assess the signals generated by the daily Bollinger Band reading. To the left of the chart, we can see that a strong downtrend in market momentum forced prices below the lower Bollinger Band. This move created our initial Buy signal (because prices began to trade outside of the 95% containment region).
As the contrarian reversal began, our next indication that an uptrend was emerging could be seen when prices broke above the 20-day SMA (Bollinger Band mid-line). The combination of these two events occurred within close proximity of one another and this should have alerted traders to the possibility of an emerging uptrend reversal:
Next, we can see that valuations move sharply higher to reach the upper boundary of the daily Bollinger Band. This occurs without market prices breaking above the upper boundary. This is key because it means markets have not become overbought (and the current rally remains sustainable within the 95% containment zone).
From here, markets continue moving higher. Eventually, we see an instance where reduced volatility constricts the Bollinger Band structure and price falls below the 20-day SMA mid-line. This is a minor signal which suggests bullish momentum is beginning to weaken. Thus, it is not surprising to see a Sell signal quickly follow (first downward arrow), as market prices finally breach the upper Bollinger Band.
At this stage, traders are left with an important decision to make: Is it time to close the trade? Or continue with the underlying bull position. Of course, these types of questions are determined by individual risk tolerance. A conservative trader might say that it is time to collect profits, given the strong gains that have already been produced in the trade.
A more aggressive trader might choose to stay in the long trade because prices haven't fallen back through the 20-day SMA after breaching the upper Bollinger Band. In fact, prices actually bounce from this line and this gives us additional evidence that the upward trend is still in play.
From here, the price continues moving higher until valuations breach the upper Bollinger Band once again (second downward arrow). On this second break, the trend has reached its exhaustion point (which becomes evident when prices ultimately fall below the 20-day SMA). At this stage, all signals to close the long trade have been sent any anyone with a long position is able to collect sizable gains.
In the period that unfolds, we can actually see a second buy signal sent as prices breach the lower Bollinger Band and reverse back through the 20-day SMA from below. In this case, traders would be able to establish a re-entry for bullish positions and take long trades once again.
Bollinger Bands offer traders an excellent way to trade using the market’s natural volatility. In the chart example below, we can see that prices have fallen sharply through the lower Bollinger Band. This sets a buy signal to go long gold at $1,490.50 as prices are now expected to move higher.
Stop losses for the trade can be set at $1,486.50 and this allows us to set a profit target at $1,510.20. These trading parameters allow us to keep a favorable risk-reward ratio of at least 3:1 on every market position.
Once this target is reached, markets begin sending strong sell signals, which could be used to establish short positions at $1,517.50. Stop losses could be placed above prior highs at $1,520.50. Any breach of this level would be unlikely because prices already trade outside of the upper Bollinger Band level. Once prices fall to a 3:1 risk-reward requirement, traders can close the trade near $1,488.20 to take profits.
Of course, Bollinger Bands should not be thought of as a stand-alone trading system. Instead, Bollinger Bands can be used to provide market traders with important information regarding the potential price volatility of an asset.
When Bollinger Bands become constricted, it becomes more likely that markets are on the verge of an explosive move. Conversely, widening Bollinger Band activity indicates a heightened possibility for a trend reversal as markets will eventually need to revert to the mean.
Expert traders will often use Bollinger Bands in conjunction with another non-correlated indicator like the Moving Average Convergence/Divergence (MACD) or the Relative Strength Index (RSI). These secondary indicators can help to provide additional confirmation of the Buy/Sell signals that are generated by the Bollinger Bands themselves.
Bollinger Bands help investors assess new trading opportunities based on key factors like trend direction, price volatility, and underlying momentum. In this way, Bollinger Bands are designed to provide tools needed to discover trading opportunities with higher probabilities of success. These indicators can be applied to any asset class and can be used on any charting time frame (although longer-term charts tend to be associated with stronger trend readings). All combined, Bollinger Bands offer traders another great tool to have in the investment toolbox when determining the reliability of new trade ideas.
As a trading system, Bollinger Bands revolve around price averages and market deviations from those price averages. When prices move rise above their historical averages and reach (or exceed) the upper Bollinger Band, the asset becomes overbought. Conversely, the asset becomes oversold when prices move below their historical averages and reach (or exceed) the lower Bollinger Band.