Bollinger Bands are a powerful technical analysis tool created by John Bollinger. They measure market volatility and identify potential overbought or oversold conditions. This indicator plots two bands around a simple moving average, typically set over 20 periods. The distance between these bands adjusts dynamically based on price volatility, widening during turbulent markets and contracting during calm periods.
Traders favor Bollinger Bands for their versatility. They provide actionable insights when combined with other analytical tools, helping to refine entry and exit points. This guide explores their calculation, key trading strategies, and practical applications.
Understanding Bollinger Bands as a Volatility Indicator
Bollinger Bands primarily serve as a volatility gauge. The space between the upper and lower bands reflects the current volatility level. Wide bands suggest high volatility, indicating larger price swings. Narrow bands signal low volatility, often preceding significant price movements.
Many traders also use these bands to spot overbought and oversold conditions. When prices near the upper band, the asset may be overbought. Conversely, prices approaching the lower band might indicate oversold conditions. However, these signals should never be used in isolation.
How to Calculate Bollinger Bands
The calculation process is straightforward. Begin with a 20-period simple moving average (SMA) of the closing prices. Next, compute the standard deviation of these same closing prices over 20 periods. The upper band is the SMA plus twice the standard deviation. The lower band is the SMA minus twice the standard deviation.
The standard deviation is key because it quantifies volatility. While the 20-period SMA and a two standard deviation multiplier are standard, these parameters can be adjusted. For a 50-period moving average, John Bollinger suggested increasing the multiplier to 2.1. For a 10-period average, a multiplier of 1.9 is often better.
Effective Trading Strategies with Bollinger Bands
While insightful, Bollinger Bands are most effective when confirmed with other indicators. Relying on them alone can lead to false signals. Here are several proven strategies.
The Squeeze Play
A "squeeze" occurs when the bands narrow significantly, indicating extremely low volatility. This compression often precedes a period of high volatility and a potential price breakout. Traders watch for the squeeze to identify upcoming trading opportunities. The direction of the breakout, however, is not signaled by the bands themselves and requires additional confirmation.
Trading Breakouts and Band Walking
Approximately 90% of price action occurs within the bands. A close outside the bands is a significant event, known as a breakout. While breakouts can signal the start of a new trend, they do not indicate its direction.
In strong trends, prices may "walk the band," consistently touching or slightly breaking the upper band in an uptrend or the lower band in a downtrend. This demonstrates sustained strength. For instance, repeatedly touching the upper band in a bull market shows strong buying pressure, even if the asset seems overbought. To time entries and exits, combine this observation with momentum indicators like the RSI. You can discover powerful confirmation techniques to validate these signals.
Identifying W-Bottoms and M-Tops
These patterns help spot potential reversals.
A W-Bottom is a bullish reversal pattern. It forms in four steps:
- Price declines to or below the lower band.
- A rebound occurs toward the 20-period SMA.
- Price declines again, making a lower low but staying above the lower band.
- The price then breaks above the high point of the first rebound, confirming the pattern and signaling a potential upward move. This can be confirmed with a bullish MACD crossover.
An M-Top is the bearish equivalent. It also forms in four steps:
- Price rallies to or above the upper band.
- A pullback follows toward the 20-period SMA.
- Price rallies again but fails to break the upper band.
- A subsequent break below the low point of the pullback confirms the pattern and signals a potential downward move, often confirmed by a bearish MACD crossover.
Bollinger Bands vs. Keltner Channels
Bollinger Bands are often compared to Keltner Channels. Both are volatility-based indicators, but they calculate their bands differently.
Bollinger Bands use a simple moving average and standard deviation. Keltner Channels use an exponential moving average (EMA) and the Average True Range (ATR). This makes Keltner Channels generally smoother and more responsive to recent price changes due to the EMA. Bollinger Bands can be more reactive to sudden volatility spikes because standard deviation is more sensitive than ATR.
Practical Application Examples
Example 1: Combining with RSI
A stock is in a strong uptrend, consistently "walking" the upper Bollinger Band. The bands alone don't signal when to sell. However, the Relative Strength Index (RSI) can show overbought conditions (e.g., above 70) just before the price pulls back toward the moving average. This combo helps lock in profits.
Example 2: Spotting a W-Bottom
An asset's price drops sharply, closing below the lower band. It then rebounds to the 20-SMA. The next drop creates a new low, but the closing price stays above the lower band—a key detail. When the price finally breaks above the high of the first rebound, it confirms the W-bottom and a potential long entry, especially if the MACD also gives a bullish signal.
Frequently Asked Questions
What is the best time frame for Bollinger Bands?
The 20-period setting is the standard for most time frames, from minutes to daily charts. It offers a reliable balance between responsiveness and smoothing out market noise. Ultimately, the best setting depends on your trading style and the asset's volatility.
Can Bollinger Bands be used as a standalone trading system?
It is not recommended. While they excel at measuring volatility and identifying potential setups, they provide few standalone trade signals. For higher-probability trades, always explore more strategies that combine them with momentum or volume indicators like the RSI or MACD.
How reliable are overbought and oversold signals from Bollinger Bands?
They are context-dependent. In a strong trend, an asset can remain "overbought" (touching the upper band) for extended periods. These signals are best used in ranging markets or when combined with other tools to confirm a potential reversal.
What does a double top or bottom touching the bands indicate?
A double top that forms near the upper band can be a strong reversal signal (M-Top), especially if the second top fails to breach the band. Similarly, a double bottom near the lower band (W-Bottom) that holds can signal a bullish reversal. Confirmation from other indicators is crucial.
Why do the bands sometimes expand rapidly?
Rapid expansion occurs after a volatility squeeze. When the price breaks out from a period of low volatility, the resulting surge in trading activity causes the standard deviation to increase quickly, pushing the bands apart. This often marks the start of a new trend.
How can I avoid false breakout signals?
To filter false breakouts, wait for a candle to close outside the band. Then, seek confirmation from volume (a spike on the breakout) or a momentum indicator like the MACD to see if it supports the direction of the breakout.
Conclusion
Bollinger Bands are an indispensable tool for assessing market volatility and generating trading ideas. Their true power is unlocked when they are used to confirm signals from other technical indicators. By understanding strategies like the squeeze, band walking, and reversal patterns, traders can make more informed decisions and better manage risk.