Stock Chart Indicator: Bollinger Bands
How to trade using Bollinger Bands?
Welcome to another part of our technical analysis series where we look into how you can place your trade (buy or sell) by looking at what the indicators tell you. Before this, we have looked into things like how stock charts, volume, moving averages, relative strength index, and moving average convergence divergence can send you ‘signals’ as to when it is likely the best time to place your buy or sell.
Now, we will look into another one of these indicators that are used by traders, although personally, I do not frequently use it. Why? We’ll get to that later in this article.
What are Bollinger Bands?
It is a tool used by traders in financial markets to analyze price volatility and identify potential trend reversals. It consists of three lines: the middle band, the upper band, and the lower band.
The middle band: It is typically a simple moving average (SMA) of the price over a certain period, such as 20 days.
The upper and lower bands: They are calculated based on the standard deviation of the price from the middle band. They are typically placed at a certain number of standard deviations away from the middle band, often 2 standard deviations.
What the heck?
We’ll simplify. So, here’s how it goes. Bollinger bands simply give you a range of possible price movements based on their previous patterns. For example, if the price of Stock ABC on Monday is $100, based on its previous price movements, the Bollinger band can give you an upper, middle, and lower band. The upper band can be, say $103, while its middle line can be $100, and its lower band can be $97.
The middle band tells you what the average price movement for the Stock is, which is based on its 20-day Simple Moving Average (SMA). If you don’t know what an SMA is, you can read it here for more details, but you can just say it’s the average price movement for that stock.
The upper and lower band is where they incorporate a standard deviation into the equation. What standard deviation does is that it looks at previous data, to tell you in the best-case scenario, how high the price can go for that particular day, or in the worst-case scenario, how low can it go.
Put it like this. You have two friends who are doing archery, and one friend, say, Friend A has more stable hands compared to another Friend B (based on their previous attempts). When friend A is about to shoot his arrow, you can tell that if he aims for the bullseye, the arrow might not hit it, but the range that the arrow would miss might not be too far. As for Friend B, you can anticipate that he might have his arrow flying above the barn behind the target or deep into the ground.
In the same way, the more volatile an asset is, the wider the distance between the upper and lower band of the Bollinger band is.
Do you have to know how to calculate Bollinger Bands?
No, you don’t. You can just head over to any charting software available online and add “Bollinger Band” into the chart function. They will automatically show you the upper and lower band. If you still want to learn how to calculate it, it’s a noble pursuit, and we do understand that some people need to know the rationale behind something to be able to trust it. Still, we won’t be teaching that for now, but we will tell you about the rationale behind Bollinger Bands.
Why Bollinger Bands?
We already knew a few facts about Bollinger Bands: It provides you with a price range; It uses standard deviation to measure the range mentioned; it uses previous price movement data to come up with the range.
The reason people use Bollinger Bands is that the concept of Standard Deviation is a commonly used tool to see how far the numbers can deviate. So, by adopting this proven statistical measure, you can have a better insight into how far the price can move — i.e., how volatile it is, and at which point the price might go for reversals.
How to use it in your trade?
The way that a Bollinger Band is used is very simple, you can imagine the middle line (the SMA) is like a magnet, where if the price goes too close to the upper band, it will fall back to the middle line. If it goes down too far, it will rise back up again.
So, the basic rule is that when the price moves too close to the upper band, you sell or short-sell, if it moves too close to the lower band, you buy. BUT here’s the thing, if you look at the graph below, you can see that the price always moves back to the middle line (the blue dotted line) — cool right? But here’s the catch…
If you see above, we marked successful buys in green, successful sells in red, and the ones that failed in black (we didn’t mark everything, tho). The issue with Bollinger Bands is that the middle line moves up and down.
So, take the first black circle as an example, even if you short-sell and the price reverts back from the upper band to the middle line, the middle line has already risen so high that even if the price moves closer to the middle line, it is at a point that is higher than the point when you initiated your short sell. So, this is why personally I don’t quite use the Bolinger Bands (note: this is the writer’s own perspective).
On one side, Bollinger Band is better used when the asset is a bit volatile because the whole purpose of it is to make a profit from the movement of the price, if you pick a stable stock, you can still make a profit, but it’s marginally small and usually not worth your time. On another side, if you go for the volatile assets, the middle line will rise and fall along with how volatile the price is, so you can be prone to false signals at times.
So… is Bollinger Bands bad? No. You can pair it with other indicators to get a more accurate insight into the market sentiments. One indicator is never enough for anything.
On another note, you can just use it to measure price volatility if you’re investing and you want your portfolio to consist of assets with different risk levels. Just look for assets with different ranges of gap sizes between their upper and lower band.
Using Bollinger Bands in Real Life
Now, if you look at the charting software (we use Koyfin for this — not a promoted content), the settings for the Bollinger Band have two main toggles: length and standard deviation.
Length here refers to the number of periods, and the most used number of periods is 20. Note, 20 here depends on the size of your data, it can be 20 minutes, 20 days, 20 weeks, or even 20 months, depending on the scale of the data you want to use.
Standard deviation is — well, the standard deviation. And the most commonly used standard deviation for any stock is usually 2.
Why 20 & 2? Can you change it?
You can change it.
Length: you can change it to a lower number to have a Bollinger Bands that is more sensitive to short-term price movements, go higher if you want a Bollinger Bands that is keener towards long-term price movements.
However, there are many reasons why most traders usually just stick with 20.
- The length of 20 is often used as it represents a rough approximation of the number of trading days in a month (assuming a five-day trading week). This allows traders to assess price movements within a monthly timeframe, which can be useful for identifying medium-term trends and patterns.
- The default setting of 20 for Bollinger Bands ensures that the standard deviation calculations for the upper and lower bands are based on a reasonable sample size. It helps maintain consistency and comparability across different assets and timeframes.
- Many trading platforms and charting software use a default length of 20 for Bollinger Bands, so traders often stick with this setting out of convenience or familiarity.
Standard deviation: You can change it to a higher number like 2.5 or 3 to get a wider band, but it’s not really advisable in many cases, because standard deviation is a principle from ‘the school’ of statistics, and there is this general understanding in statistics where the standard deviation of 2 is considered as a standard measure for capturing a significant portion of price data within a normal distribution.
- Bollinger Band is a tool used by traders in financial markets to analyze price volatility and identify potential trend reversals.
- It consists of three lines: the middle band, the upper band, and the lower band.
- The wider the gap between the upper and lower band, the more volatile an asset is.
- Bollinger Bands is great with assets that are more volatile.
- Its signals can be misleading when the trend is strong.
- Use other indicators to make better predictions.
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