Every trader needs to know how to use Bollinger bands effectively. Of all the trading tools out there, Bollinger bands are among the most popular for good reasons. Bollinger bands are easy to read and use.
Bollinger bands show when a price trend is continuing and when likely to reverse within a trending channel.
Bollinger bands show when the price is contracting during consolidation phases and conversely when volatility is increasing and price breakouts becoming more likely.
Bollinger bands defined
Bollinger bands are calculated either side of a simple moving average of a stock price action chart. The upper band is two standard deviations above the moving average and the lower band is two standard deviations below the moving average. The most used period for Bollinger bands is a 20-day period.
I am guessing that many readers will have read the definition and thought something like, OK so standard deviations are some sort of statistical measure related to calculating an average.
To remind ourselves, if values are normally distributed around a mean then roughly 67% will fall within one standard deviation from the mean value and 95% will tall within two standard deviations from the mean value.
To create the Bollinger bands
So to create the Bollinger bands, we do the following:
- we calculate the simple 20-day moving average of a sequence of daily price data
- for each data point we calculate the standard deviation, which is the square root of the sum of the squares of all the differences between each price in the 20-day series and the average on that day.
- we plot a line 2 standard deviations above the 20-day moving average. This is the upper Bollinger band
- we plot another line 2 standard deviations below the 20-day moving average. This is the lower Bollinger band.
Most online broker services and charting services will calculate the Bollinger bands for you and allow you to select averages other than a simple average, such as exponential or other types of smoothing, and select other periods. The most popular settings though are for a 20-day simple moving average.
Let’s see what that looks like for an ETF for a recent period of price action. For this example let’s look at the SPDR ETF that tracks the Standard and Poor’s 500 Index, symbol SPY for the period 7 February to 4 September 2020. Here is a candlestick chart of the SPY price for that period with the Bollinger bands shown.
Source 1)Historical price data source, Yahoo Finance. Calculations, and charts by https://badinvestmentsadvice.com/
What the bands show
There are a few things we can see with the Bollinger bands.
Firstly I should note that this period of price action was one of high volatility in February and March and then steadily reducing through April and May.
The Bollinger bands widen when price action is more volatile and narrow as price is less volatile
Another simple thing to note is that the price tends to range in the lower band when price is trending down and in the upper band when price is trending up.
As we can see the price movement tends to stay inside the bands. The price tends to bounce off the band limits either in the upper where the band serves as price resistance or in the lower where the band serves as support.
In the SPY example above the price seems to bounce off the lower band repeatedly, then it crosses back over the moving average and heads into the upper band where the upper limit becomes a new resistance level. This happens a couple of times in the example above.
In that period, April and May 2020, when the price bounced repeatedly off the upper limit, this was an indicator that the price was overbought and heading for a reversal, as indeed happened in June.
The reverse is also true. If the price bounces repeatedly off the lower limit, that is an indicator that the price is oversold and is likely to correct upwards.
Price accumulation and price distribution
When the bands contract it can seem they are squeezing the price. Such periods of price contraction are important. At the bottom of a decline, and before a rise, price contraction shows accumulation. This is when money that has waited on the sidelines during a decline starts to buy back in.
At the top of a rising market, Price contractions shown by the bands narrowing indicates a period of price distribution. This is where a bull market is thinning out. Institutions are exiting and distributing stock to others who are still willing to buy. Eventually, the demand is fulfilled and supply, including short sellers take over pushing prices down.
We can see narrowing bands and price distribution to some extent in the earlier price movement of the SPY from the beginning of January 2020. Shown here.
We can also see some evidence of the bands contracting and price accumulation during the March 2020 lows in the SPY in the chart above. It isn’t that easy to see on this chart and the bounce back from the low was so rapid. Also, price accumulation probably started a little earlier than shown here.
Like all indicators based on moving averages, Bollinger bands are lagging indicators. They tell us what price action has happened and where it is now in relation to where it was.
We could also rather cynically point out that since the bands are constantly adjusting themselves, even though they may become levels of price resistance and price support, they are only useful for predicting future levels of price support or resistance if the channels stay somewhat constant and volatility doesn’t change much.
Other indicators tend to give more meaningful indications of price reversals. Some or the main indicators are reviewed on this site including, the MACD, the ADX system, the Relative Strength Indicator, and the Stochastic oscillator.
Answers to questions
Q. Are Bollinger bands effective?
A. Yes. The Bollinger Bands are effective in showing price trending within a channel. When the price knocks repeatedly against the lower limit, this is an indication that the price is oversold and will likely correct upwards. When the price knocks repeatedly against the upper limit, this is an indication that the price is overbought and will likely correct in a downward direction. It should be noted though that Bollinger bands are effective for showing and plotting short-term price corrections and not major trend reversals.
Q. What is the best setting for the Bollinger bands?
A. The most popular settings for the Bollinger bands are to use a simple 20-day moving average and set the upper and lower bands at plus and minus 2 standard deviations above and below the moving average. Because these are the most popular settings they are probably the best settings to use.
Q. How do you analyze the Bollinger bands?
A. The Bollinger bands are a good indicator of price moving within a trending channel.
Q. What are Bollinger bands used for?
A. The Bollinger bands can be used effectively to benefit from price movements within a trending channel.
Q. What is the best trading strategy to use with the Bollinger bands?
A. The Bollinger bands are best used as a way to profit from short-term price movements within a trending channel.The Bollinger bands can be a good indicator of price distribution at the top of a bull market and conversely price accumulation at the bottom of a bear market, they can help show when a price reversal is likely. However, you will usually need to refer to other tools to determine how far a major reversal is likely to go when it happens.
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|↑1||Historical price data source, Yahoo Finance. Calculations, and charts by https://badinvestmentsadvice.com/|