What are Bollinger Bands
Bollinger Bands consist of a center line and two price channels (bands) above and below it.
The center line is a simple or exponential moving average, usually 20 period, whilst the price channels are determined by the standard deviations of the stock price:
- the upper bandline is the value of the middle line (moving average) plus the value of twice the standard deviation,
- the lower bandline is the value of the moving average minus the value of twice the value of the standard deviation.
Both the parameters of the moving average (number of periods and kind of moving average) and the parameter of the standard deviation number of times to add and substruct can be personalized by the trader.
Because standard deviation is a measure of volatility, Bollinger Bands adjust themselves to the market conditions.
When the price becomes more volatile, the bands get wider, while during less volatile periods the bands get slimmer, and this enlarging or tightening of the bands is a clear indication of the volatilty of the asset price.
The bands will then expand as the price becomes volatile and will contract when the price becomes less volatile.
Bollinger issues a set of 22 rules as to how use the Bollinger Bands.
As indicated by rule 21st,
“Bollinger Bands can be used on bars of any length, 5 minutes, one hour, daily, weekly, etc. The key is that the bars must contain enough activity to give a robust picture of the price-formation mechanism at work. “
Bollinger Bands on EUR/USD 5 min chart (20-Simple moving average +/- 2 standard deviations)
Basic trading strategy with overbought and oversold areas
Statistically, two standard deviations should include roughly 96% of all closings:
if the price closes outside of bands, it is unlikely to continue to do so without retracing back to the average first.
But Bollinger says at rule 14th
“Make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands.
The distribution of security prices is non-normal and the typical sample size in most deployments of Bollinger Bands is too small for statistical significance.
(In practice we typically find 90%, not 95%, of the data inside Bollinger Bands with the default parameters) “
When stock prices are in the upper band, the stock is deemed to be in an overbought area, creating the conditions for a sell signal, and when it is in the lower band, the price is considered oversold, triggering a potential buy signal.
The very basic strategy with the Bollinger Bands is:
- buy when the price touches the lower band line,
- sell when the prices touches the lower band line.
There are different versions on when to enter the market, whether when the price goes through the lines intraday or when the price closes through them.
The risk with this strategy is that the price may continue the uptrend after the break of the upper resistance channel and may continue down after the break of the lower support channel, as stated by Bollinger at rules n° 7th and n°8th of his 22-rule set:
“7. In trending markets price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.”
“8. Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.)”
This strategy has been denied by Bollinger himself at rule 6th of the list of 22 rules about the use of Bollinger Bands:
“6. Tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.”
For the above reasons Bollinger Bonds analysis shall be combined with another indicator as to have a confirmation of the buying/selling signal and with a strict exit stop loss technique.
A simple strategy indicated by Bollinger
A simple use of the Bollinger bands is as a trend indicator.
In an uptrend, the price will move between the midpoint of the bands, which happens to be the 20-period exponential moving average (EMA) and the upper band.
If the trend is strong, you will see this occurring. You would have an opportunity to buy into the strong trend when prices retrace back to the 20-period EMA and a demand level. Your target would be supply and a touch of the upper band.
Weakness in the trend would be signaled by the first touch of the bottom band. While this does not initially signal the end of the bullish move, it is a warning that the end may be near.
If the trend is to turn negative, you will first notice lower highs and lower lows.
Should the downtrend become strong, then price will bounce between the 20-period EMA and the lower band.
Once again, a sign of weakness of the bearish trend would be a touch of the upper band.
This does not necessarily mean a reversal is coming, but it does offer a signal to be cautious in continuing to short the markets.
Bollinger Bands as confirmation of setups or trading strategy
The bottomline of this post is that Bollinger Bands must be combined with another indicator to spot entry points, as indicated in the last of 22 rules which says, or in other words the Bollinger Bands shall be used as confirmation of trading setups:
“22. Bollinger Bands do not provide continuous advice; rather they help indentify setups where the odds may be in your favor.”