Bollinger Bands® are a technical analysis tool that can indicate price volatility, helping traders anticipate opportunities in the market.
Developing the method for Bollinger Bands® took some time and experimentation, but creating the roll-off-the-tongue name did not. As financial analyst John Bollinger says on the website for his brand, the memorable name for this financial tool happened on the spot.
“Bill Griffeth, an on-air host for the Financial News Network, asked me what I called my bands on air,” says Bollinger. “I had presented a chart showing an unconfirmed tag of my upper band and explained that the first down day would generate a sell signal. Bill then asked me what I called those lines around the price structure, a question that I was totally unprepared for, so I blurted out the alliteratively obvious choice: ‘Bollinger Bands.’”
Bollinger Bands can be a helpful indicator for traders looking to identify trends, possible price targets, and potential volatility. While there is no way to fully predict market results, an indicator can detect when the odds may be in your favor.
THE BASICS OF BOLLINGER BANDS
Developed in the early 1980s, Bollinger Bands are a technical analysis tool that can help traders evaluate price action as well as volatility. These bands determine where the likely support or resistance levels might be.
Bollinger Bands consist of a middle band, which is usually a simple moving average, as well as an upper band and a lower band. The upper and lower bands are normally two standard deviations above or below the average, though the standard deviation can be adjusted based on a user’s preference. Bollinger Bands typically use a period of 20 days to determine the moving average.
By comparing a security’s position relative to the bands, a trader may identify the relative high and low prices of a market. Traders consider the price high when it is close to the upper band and low when it is closer to the lower band. Besides price action, the width of the band may indicate volatility; narrower bands show lower volatility while wider ones suggest higher volatility.
Investors can use Bollinger Bands on several different financial instruments, including equities, indices, foreign exchange, commodities, futures, options, and bonds. They can also be used to measure bars of any length, be they five minutes, one hour, daily, or weekly. As long as the bars have enough activity, traders can use the bands to recognize patterns.
Analyzing the charts with Bollinger Bands can help traders identify patterns that indicate the beginning or ending of a trend. For example, Bollinger Bands might show a “buy channel” and a “sell channel” based on the prices’ relation to the moving average.
When the price of the security touches the Bollinger Band above the moving average, the price is in the “buy channel,” suggesting upward momentum in the market. If the price continually stays in the buy channel, investors may consider the price to be overbought, prompting them to sell. On the other hand, when the price continually touches the lower band, traders may consider the price to be oversold, prompting them to buy.
However, according to Bollinger, traders should be careful not to consider these trends as signals.
“Tags of the bands are just that, tags not signals,” says Bollinger in his set of 22 rules. “A tag of the upper Bollinger Band is NOT in and of itself a sell signal.”
Another strategy is to recognize the distance of the bands in relation to market volatility. The example in the image below shows a period of contraction between the bands. Since the candles are closer to the moving average, this suggests a period of low volatility.
Periods of low volatility often reveal an incoming period of increased volatility, which can lead to possible trading opportunities.
LIMITATIONS WITH BOLLINGER BANDS
While the Bollinger Bands can highlight patterns and indicate potential trends, there are still limitations. Even if a trader can recognize a period of low volatility and anticipate a trend reversal, the bands can’t predict the exact moment when the period of high volatility may occur.
One way to augment the value of Bollinger Bands is to pair them with other indicators, especially ones that measure different criteria. Since the bands indicate price volatility, pairing them with a volume indicator will complement them better than pairing two indicators that measure similar benchmarks.
Bollinger Bands are a lagging indicator that reacts to price movements rather than predicting. Nonetheless, by understanding market trends, the bands can be useful for determining a trader’s price targets to buy or sell a security.