How Bollinger Bands Work

Bollinger Bands are plotted on a price chart and consist of the following components:

Middle Band: This is typically a 20-period SMA of the security’s price.

Upper Band: This is the middle band plus two standard deviations.

Lower Band: This is the middle band minus two standard deviations.

The bands expand and contract based on the volatility of the security. When the price is more volatile, the bands widen; when the price is less volatile, the bands contract.

Calculation of Bollinger Bands

To calculate Bollinger Bands, follow these steps:

1.Calculate the 20-period SMA:

SMA=(P_1+P_2+⋯+P_20)/20

Where (P) represents the closing prices over 20 periods.

2.Calculate the standard deviation (SD):

SD=√((∑(P_i-SMA)^2)/20)

3.Calculate the upper and lower bands:

Upper Band=SMA+(2×SD)

Lower Band=SMA−(2×SD)

Interpretation of Bollinger Bands

1. Overbought and Oversold Conditions

Overbought: When the price touches or exceeds the upper band, it may indicate that the security is overbought and could be due for a price correction.

Oversold: When the price touches or falls below the lower band, it may indicate that the security is oversold and could be due for a price increase.

Example: If a stock’s price consistently touches the upper band, it may signal that the stock is overbought and a price decline could follow. Conversely, if the price consistently touches the lower band, it may signal that the stock is oversold and a price increase could follow.

2. Squeeze

The “squeeze” is a period of low volatility where the bands contract closely around the SMA. This often precedes a significant price movement. When the bands start to widen again, it can signal the beginning of a new trend.

Example: If the bands contract tightly around the SMA and then start to widen, it may indicate that a breakout is imminent, and traders should watch for a potential trend in either direction.

3. Walking the Bands

During strong trends, prices can “walk the bands,” meaning they stay close to the upper or lower band for extended periods. This indicates a strong momentum in the direction of the trend.

Example: In a strong uptrend, the price may consistently touch or stay near the upper band, indicating strong bullish momentum.

Practical Application of Bollinger Bands

Identify Entry and Exit Points: Use Bollinger Bands to identify potential entry and exit points based on overbought and oversold conditions.

Confirm Trends: Use Bollinger Bands in conjunction with other technical indicators to confirm the strength of a trend.

Monitor Volatility: Watch for the squeeze to identify periods of low volatility that may precede significant price movements.

Conclusion

Bollinger Bands are a versatile and widely-used tool in technical analysis that helps traders and investors identify overbought and oversold conditions, monitor volatility, and confirm trends. By incorporating Bollinger Bands into your trading strategy, you can make more informed decisions and improve your overall trading performance. Remember, while Bollinger Bands are powerful tools, they should be used in conjunction with other forms of analysis and risk management to achieve the best results.