Bollinger Band® Definition
A Bollinger Band® is a technical analysis tool defined by a set of trendlines plotted two standard
deviations (positively and negatively) away from a simple moving average (SMA) of a security's
price, but which can be adjusted to user preferences.
Bollinger Bands® were developed and copyrighted by famous technical trader John Bollinger,
designed to discover opportunities that give investors a higher probability of properly identifying
when an asset is oversold or overbought.
KEY TAKEAWAYS
• Bollinger Bands® are a technical analysis tool developed by John Bollinger for generating
oversold or overbought signals.
• There are three lines that compose Bollinger Bands: A simple moving average (middle band)
and an upper and lower band.
• The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple
moving average, but can be modified.
How To Calculate Bollinger Bands®
The first step in calculating Bollinger Bands® is to compute the simple moving average of the
security in question, typically using a 20-day SMA. A 20-day moving average would average out the
closing prices for the first 20 days as the first data point. The next data point would drop the
earliest price, add the price on day 21 and take the average, and so on. Next, the standard
deviation of the security's 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 spread out 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.
Here is this Bollinger Band® formula:
BOLU=MA(TP,n)+m∗σ[TP,n]BOLD=MA(TP,n)−m∗σ[TP,n]
where:
BOLU=Upper Bollinger Band
BOLD=Lower Bollinger Band
MA=Moving average
TP (typical price)=(High+Low+Close)÷3
n=Number of days in smoothing period (typically 20)
m=Number of standard deviations (typically 2)
σ[TP,n]=Standard Deviation over last n periods of TP
What Do Bollinger Bands® Tell You?
Bollinger Bands® are a highly popular technique. Many traders believe the closer the prices move
to the upper band, the more overbought the market, and the closer the prices move to the lower
band, the more oversold the market. John Bollinger has a set of 22 rules to follow when using the
bands as a trading system.
In the chart depicted 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. However, these conditions
are not trading signals. The bands give no indication when the change may take place or which
direction price could move.
Breakouts
Approximately 90% of price action occurs between the two bands. Any breakout above or below
the bands is a major event. The breakout is not a trading signal. The mistake most people make is
believing that that price hitting or exceeding one of the bands is 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® are not a standalone trading system. They are simply 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. He believes
it is crucial to use 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).
Because they are computed from a simple moving average, they weight older price data the same
as the most recent, meaning that new information may be diluted by outdated data. Also, the use
of 20-day SMA and 2 standard deviations is a bit arbitrary and may not work for everyone in every
situation. Traders should adjust their SMA and standard deviation assumptions accordingly and
monitor them.
