Famous financial analyst John Bollinger developed Bollinger Bands in the early 1980s and trademarked this term in 2011. Initially, it was known as trading bands but John later evolved this concept and called it Bollinger Bands. It was designed to offer unique instincts that give investors a higher probability of determining a volatility range in which a particular security price moves up or down.
There are three lines comprising Bollinger bands: the lower, the upper Bollinger bands, and the middle. Both upper and lower bands are used in pairs with a moving average. One of the more common calculations uses a 20-day simple moving average (SMA) for the middle band. Nonetheless, you can customize the combinations. Check out a breakdown of the image below.
Bollinger Band Calculations
First, calculate a simple moving average. Next, calculate the standard deviation over the same number of periods as the simple moving average. The upper band is calculated by taking the middle band and adding twice the daily standard deviation to that amount. The lower band is calculated by taking the middle band minus two times the daily standard deviation.Typical values used:
- Short term: 10-day moving average, bands at 1.5 standard deviations. (1.5 times the standard dev. +/- the SMA)
- Medium-term: 20-day moving average, bands at 2 standard deviations.
- Long-term: 50-day moving average, bands at 2.5 standard deviations.
How To Trade Bollinger Bands Effectively
The best Bollinger Band strategy is to use them to identify oversold and overbought market conditions. If the stock price touches the upper Bollinger bands it is deemed as overbought and is due for a pullback. Especially if the price severely pierces the Upper Bollinger Band with a lot of strength. Check out the example below of Lucid Motors, where the price was severely above the Upper Bollinger Band, hinting at a pullback that followed quickly.
On the other hand, if you go on the lower Bollinger band it is considered oversold. The prices have perhaps fallen too much and are due to bounce (but that doesn't mean they will, that is where experience comes into play!).
Note that the use of Bollinger bands varies with different traders; some traders choose to buy when prices are near the lower Bollinger bands. Most traders will exit when the price line touches the middle line. Others may buy when the price line breaks above the upper band and then sell when the price falls below the lower band.
Prices may also move really quickly in the opposite direction if you touch a Bollinger band. When the bands tighten during a period of low volatility, it increases the chances of a sharp price move in the opposite direction hence beginning a trending move this is called a Bollinger Squeeze.
There are several different ways to play Bollinger Bands. I love playing the oversold and overbought trading setups, where prices trade outside Bollinger Bands for several days (this setup takes a lot of practice and a solid trading system). Additionally, Bollinger Band Squeezes, whereas volatility comes to a standstill and foreshadows a huge move about to take place, are another useful trick (I don't play this one as much, however).
Conclusion
The beauty of Bollinger Band calculations is that using the standard settings, 95% of the time, the price will be within the bands. 5% of the time, it is not, which means often price will trade in the opposite direction soon after, as shown with the Lucid Motors example above. Being able to capture the high probability of a reversal is one of the main reasons Bollinger Band strategies are such a powerful indicator and a must for all traders.
Like everything in the market, it is not straightforward. You will need to experience this indicator live and do a ton of backtesting to get a good feel of its capabilities. Live practice is the only way to use Bollinger Bands effectively.
Check out my other articles on the ADX and RSI indicators that can help you make money. Also, if you are interested in more trading systems, check out my guide to Using Ichimoku Clouds For Daytrading and The Elder Impulse System.