Bollinger Bands are applied directly to price charts, providing a gauge for how strong a trend is, and spotting potential bottoms and tops in stocks prices. Band width fluctuates based on volatility; the ability for Bands to adapt to changing market conditions makes it a popular indicator amongst traders. To use Bollinger Bands effectively, we must understand how they work, their trading applications, and pitfalls.
What are Bollinger Bands?
Bollinger Bands® are a volatility based indicator, developed by John Bollinger, which have a number of trading applications.
There are three lines that compose Bollinger Bands: A simple moving average (middle band) and an upper and lower band. These bands move with the price, widening or narrowing as volatility increases or decreases, respectively. The position of the bands and how the price acts in relation to the bands provides information about how strong the trend is and potential bottom or topping signals.
Bollinger Bands are used on all timeframes, such as daily, hourly or five-minute charts. Bollinger Bands have two adjustable settings: the Period and the Standard Deviation. The Period is how many price bars are included in the Bollinger Band calculation. The number of periods used is often 20, but is adjusted to suit various trading styles.
The Standard Deviation is typically set at 2.0, and determines the widths of the Bands. The higher the Standard Deviation, the harder it will be for the price to reach the upper or lower band. The lower the Standard Deviation the easier it is for price to “breakout” of the Bands.
Bollinger Bands denoted (20,2) means the Period and Standard Deviation are set to 20 and 2, respectively.
The indicator is calculated using the following formula. First calculate the Middle Band, then calculate the Upper and Lower Bands.
- Middle Band = 20-day simple moving average (SMA)
- Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
- Lower Band = 20-day SMA – (20-day standard deviation of price x 2)
Where SMA = the sum of closing prices over n periods / by n.
Figure 1 shows how Bollinger Bands looks on a chart as they move and adapt with price.
Trading with Bollinger Bands
The first way to use Bollinger Bands is for analysis. Some common occurrences provide us with information on the direction and strength of the trend. This information can then be used to confirm trade signals from other indicators or strategies to make trades.
- If an uptrend is strong it will reach the upper band on a regular basis. Reaching the upper band shows the stock is pushing higher and buying activity remains strong.
- When the price pulls back, within the uptrend, if it stays above the middle band and then moves back to upper band it shows a lot of strength.
- During an uptrend the price shouldn’t break below the lower band; if it does it warns the uptrend has slowed and may be reversing.
The same principles apply to a downtrend.
- If a downtrend is strong it will reach the lower band on a regular basis. Reaching the lower band shows selling activity remains strong.
- When the price pulls back (higher), within the downtrend, if it stays below the middle band and then moves back to lower band it shows a lot of strength.
- During a downtrend the price shouldn’t break above the upper band; if it does it warns the uptrend has slowed and may be reversing.
These are general guidelines for trading with Bollinger Bands to help analyzed the trend. Adjusting the Bollinger Band settings may help avoid getting false signals from these guidelines.
Another way to use Bollinger Bands is for trading W-Bottoms and M-Tops.
A W-Bottom signals a reversal from a downtrend into an uptrend.
Initially there is a wave lower, which gets close to or moves below the lower band. The price then pulls back to the middle band or higher, and proceeds to create a lower price low than the prior wave, but doesn’t close below the lower Bollinger Band. When the price moves above the high of the prior pullback the W-Bottom is in place. A long trade is initiated and a stop is placed below the recent lows.
The W-Bottom is similar to a Double Bottom chart pattern. One potential profit target is to add the height of the W-bottom to the breakout price. In Figure 3 the W-Bottom is roughly $1.50 high, added to a breakout price near $33, this gives a target of $34.50. If a major uptrend unfolds, a trailing stop can be used to attempt to capture more profit from the rally.
An M-Top signals a reversal from an uptrend into a downtrend.
Initially there is a wave higher, which gets close to or moves above the upper band. The price then pulls back to the middle band or lower, and then proceeds to create a higher price high than the prior wave, but doesn’t close above the upper Bollinger Band. When the price moves below the low of the prior pullback the M-Top is in place. A short trade (and exit long positions) is initiated and a stop is placed above the recent highs.
The M-Top is similar to a Double Top chart pattern. One potential profit target is to subtract the height the M-Top from the breakout price. In Figure 4 the M-Top is roughly $9 high, subtracted from a breakout price near $31, this gives a target of $22. If a major downtrend unfolds, a trailing stop can be used to attempt to capture more profit from the short position.
Bollinger Band Limitations
Bollinger Bands are a helpful indicator, but they have a number of limitations. Bollinger Bands are derived from a simple moving average, which is the average price over a certain number of price bars. This means Bollinger Bands will always react to price moves, but won’t forecast them. Bollinger Bands are reactive, not predictive.
Standard settings won’t work for all traders. Active traders may want a small number of periods or lower standard deviation, while long-term traders may prefer a greater number of periods and a greater standard deviation, so few signals are presented. By adjusting the settings though it may be more difficult to gauge the trend based on the guidelines or spot W-Bottoms or M-Tops.
M-Tops and W-Bottoms may not actually end up not being reversals, but rather just consolidations where the price continues to head in the trending direction after a false breakout. A false breakout is when the price passes through the entry point, initiating a trade, but then quickly moves back in the other direction resulting in a loss. This is why stop losses are used.
The Bottom Line
Bollinger Bands are comprised of a middle band (SMA), and upper and lower bands based on standard deviation which contract and widen with volatility. The Bands are a useful tool for analyzing trend strength and monitoring when a reversal may be occurring. Combining Bollinger Bands with M and W price patterns aids in spotting major reversal signals. Bollinger Bands are not predictive though. They are always based on historical information and therefore react to price changes, but don’t anticipate price changes. Like other indicators, Bollinger Bands are best used in conjunction with other indicators, price analysis and risk management as part of an overall trading plan.