A Bollinger Band® is a technical analysis tool defined by a set of trendlines. They are plotted as two standard deviations, both positively and negatively, away from a simple moving average (SMA) of a security's price and can be adjusted to user preferences.
Bollinger Bands® was developed by technical trader John Bollinger and designed to give investors a higher probability of identifying when an asset is oversold or overbought.
The bands widen when a stock's price becomes more volatile and contract when it is more stable. Many traders see stocks as overbought as their price nears the upper band and oversold as they approach the lower band, signaling an opportune time to trade.
How to Calculate Bollinger Bands®
The first step in calculating Bollinger Bands® is to compute the simple moving average (SMA) of the security, typically using a 20-day SMA. A 20-day SMA averages the closing prices for the first 20 days as the first data point.
The next data point drops the earliest price, adds the price on day 21 and takes the average, and so on. Next, the standard deviation of the security price will be obtained. Standard deviation is a mathematical measurement of average variance and features prominently in statistics, economics, accounting, and finance.
For a given data set, the standard deviation measures how far numbers are from an average value. Standard deviation can be calculated by taking the square root of the variance, which itself is the average of the squared differences of the mean.
Next, multiply that standard deviation value by two and both add and subtract that amount from each point along the SMA. Those produce the upper and lower bands.
Example of Bollinger Bands®
In the chart below, Bollinger Bands® bracket the 20-day SMA of the stock with an upper and lower band along with the daily movements of the stock's price. Because standard deviation is a measure of volatility, when the markets become more volatile the bands widen; during less volatile periods, the bands' contract.
The Squeeze
The "squeeze" is the central concept of Bollinger Bands®. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities.
Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. These conditions are not trading signals. The bands do not indicate when the change may take place or in which direction the price could move.
Breakouts
Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is significant. The breakout is not a trading signal and many investors mistake that when the price hits or exceeds one of the bands as a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.
Limitations of Bollinger Bands®
Bollinger Bands® is not a standalone trading system but just one indicator designed to provide traders with information regarding price volatility. John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals and indicators based on different types of data. Some of his favored technical techniques are moving average divergence/convergence (MACD), on-balance volume, and relative strength index (RSI).
Source: Investopedia, Bollinger Bands®: What They Are, and What They Tell Investors, accessed 27 December 2023, <https://www.investopedia.com/terms/b/bollingerbands.asp>
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