Bollinger Bands

Bollinger Bands refer to a technical analysis tool using the statistical chart to portray security price and volatility. It is primarily used to identify overbought and oversold points. This channel indicator was created by John Bollinger of Bollinger Capital Management in the 1980s.

It contains upper and lower bands, creating a price channel around the price movement line and capturing the fluctuations. Evaluating the price channel contributes to developing trading signals. It is widely applied for analyzing price movements of various financial instruments like stocks and currencies. However, it is also used in fields other than financial markets. For instance, it is used in the defect detection of patterned fabric.

• Bollinger Bands (BB) refers to a technical analysis tool focusing on security price and volatility to disclose overbought and oversold points. 
• It is formulated by John Bollinger of Bollinger Capital Management in the 1980s.
• The main three components are the middle, upper, and lower bands. The upper and lower bands are based on standard deviations, and an N Day Moving Average forms the middle band.
• The bands come closer during low volatility and widen during high volatility.

The Bollinger Band design contains three main components, the middle band, upper band, and lower band. The middle band is based on a simple moving average line, and the upper and lower bands present the standard deviations.

The most common time frame for moving average is 20 days for short-term analysis and 200 days for long-term analysis.

• The middle band: An N day moving average
• The upper band: K times above the standard deviation of the middle band

Generally, the k value is equal to 2

• The lower band: K times below the standard deviation of the middle band

Generally, the k value is equal to 2)

The concept is explained by using a chart from Tradingview, as given below. The middle band is the red line with respect to which the indicator calculates the standard deviation of prices. In areas where the volatility is very high, the band has shown a substantial gap between the upper and lower bands. The highest level of the upper band depicts the selling point or exit point because after that the prices show a strong tendency to move downwards steadly. The opposite is the case with lower band. Thus, this indicator can be conveniently used for identifying the overbought and oversold positions. In the below chart, the overbought points are marked in red arrows with S mentioned, whcih means now is the time to sell. Similarly the oversold ones are marked in green B, indicating the time to buy. 

Source

Standard deviation is a measure of volatility. Its integration in the technique makes it fast in reacting to the large moves and throws insight into what is happening in the market. In addition, the combination of standard deviation and moving average makes it logically consistent because moving average is used to calculate the standard deviation, and both use the same data as input.

The band tightens during low volatility and widens during high volatility. The price of a security moving above the upper band points to the overbought scenario, and the price moving below the lower band indicates an oversold scenario.

Traders can design their Bollinger Bands trading strategies based on the bands' movement. For example, When the price crosses the lower band from below and starts rising, a buy signal emerges; traders can buy and exit when the price breaks the MA line, and if the price crosses the upper band from above, a sell signal appears.

Upper band = MA(TP, n) + m ∗ σ

Lower band = MA(TP, n) − m ∗ σ

Here,

• MA:  Moving average
• σ: Standard deviation over the last n periods of TP
• TP (typical price): (High+Low+Close)/3
• n: Number of days in smoothing period
• m: Number of standard deviations

Calculation Example

In a 5-bar Bollinger Band based on the last five closes, the moving average is 25.50. Therefore, the standard deviation value derived using the moving average, the last five closes are 0.5, and the number of standard deviations is 2.

• MA(TP, n): 25.50
• σ : 0.5
• n: 5
• m: 2

Upper band = MA(TP, n) + m ∗ σ

= 25.5 + 2*0.5

=26.5

Lower band = MA(TP, n) − m ∗ σ

=25.5 – 2*0.5

=24.5

A squeeze occurs when the two bands tighten in space, that is, a decrease in the width of the band, making it narrow. It is an indicator of low volatility in the market. On the other hand, it also indicates that a period of high volatility is approaching. Hence a significant oscillation is always expected after a squeeze; it can be a price break above the upper band or a price break below the lower band that is an uptrend or downtrend is expected, and it is considered one of the best times to execute a trade.

Identifying securities or stocks with narrowing bands and low bandwidth levels is important. For example, one can locate security with bandwidth having its minimum value in six months. The traders can prepare for a volatility expansion even if the technique doesn't indicate price movement direction. Traders also use other technical indicators in conjunction to confirm the trends.

When the price level closes above the upper band, it is a positive volatility breakout. And likewise, a downside close below the lower Bollinger Band gives a negative volatility breakout. The traders will deduce a potential buy signal if the price breaks above the upper band and a potential sell signal if the price breaks below the lower band.

This is a Guide to what are Bollinger Bands. We explain trading strategies involving BBs, bandwidth indicators, and how to use this strategy. You can learn more from the following articles –

• Technical Analysis
• Oversold
• Security Analysis