Last Updated on 21 September, 2020 by Therobusttrader
What Is a Bollinger Band?
The Bollinger Band is a technical analysis tool that is used to study the price and the volatility of a certain financial instrument or commodity. Bollinger Bands are comprised of 3 lines (Bands). One of them is the simple moving average, while the other two are the standard deviations of the price (usually 2 standard deviations apart).
In simple words, the Upper and Lower bands widen during times of high volatility and contract during times of low volatility. This information can be used by traders to follow trends and time their entries as well as trail their stop-loss.
Before you understand how to make use of Bollinger Bands, it is important that you understand how to calculate them. Let’s take a look!
How to Calculate Bollinger Bands
Bollinger Bands are usually calculated on the basis of the last 20-days of trading. This is the industry standard which can be modified according to your liking. Since Bollinger Bands consist of 3 different plotted lines, here is how you can calculate each of those bands.
- Middle Bollinger Band (Simple Moving Average) = Average of the closing price for the last 20 days
- Upper Bollinger Band = (Average of the closing price for the last 20 days) + (2 standard deviations of the 20-day price)
- Lower Bollinger Band = (Average of the closing price for the last 20 days) – (2 standard deviations of the 20-day price)
Remember that there can be variations to the above-mentioned formulas. For example, some people like to first calculate the average price of the day by calculating the average of the High, Low, and Closing price prior to calculating the 20-day moving average.
Others often only calculate the Bollinger Bands based on data from 10 days as they do not believe that the data prior to that is as relevant as the data from recent days. If you are new to the concept of Bollinger Bands, you do not need to divulge into these variations. Instead, simply use the formulas mentioned above to calculate the bands and then interpret them for your analysis.
Who Invented Bollinger Bands?
Bollinger bands were invented by John Bollinger.
Watch when John Bollinger himself describes how he invented his now so widespread Bollinger bands:
How can Traders and Investors use Bollinger Bands?
Before we dive into how you can make use of Bollinger Bands, remember that this is not a tool that you should use ‘on its own’ to make trading decisions. Instead, Bollinger Bands should be used in conjunction with other trading tools of a similar type to determine investment strategy.
That said, there are a number of helpful indicators that the Bollinger Bands provide. Let’s take a look at some of them to see how they can be helpful to you. At the end, we also tell you some of the limitations of the Bollinger Band.
The Bollinger Band Squeeze
This is one of the most common uses of Bollinger Bands. From time to time, you may see a decline in volatility for a commodity or instrument. This is characterized by both the Upper and the Lower bands decreasing in their width to the Middle band. After the bands have narrowed for some time, they are signalling that a period of increased volatility lies ahead.
A perfect example of this can be seen in the chart above. After a squeeze which lasts till October 2018, the volatility increases massively which can be seen by the Upper and Lower bands widening considerably. This is quite a common trend which can be used by traders to enter or exit positions.
One thing to remember here is that the price usually develops a trend coming out of a squeeze. As such, you should be very careful when entering a new position during a Bollinger Squeeze. Only after careful research should you decide upon the next movement of the chart.
Traders who make use of Bollinger Bands probably make use of this technique more than any other. Take a look at the Bollinger band above; it is quite obvious by taking a look at the Middle Band (SMA) that the chart is moving in an upward trend. What you may not know is that you can utilize the Upper and the Lower bands to decide when to enter the position and cash in on the trend.
Since the standard Bollinger Band is two standard deviations, this means that roughly 90% of all price movements lie within the Bollinger Band. This leads to the vast majority of price movements during an up-trend or down-trend to residing within the two bands. So, the price should move between the Middle and the Upper band during an up-trend (and between the Middle and Lower band during a down-trend).
Traders can make use of this to enter a long position during a positive trend when the price is close to the lower band. Alternatively, traders can enter a short position when the price is close to the upper band but the trend is negative. Here is an example of a long trade that’s entered once the price crosses under the lower band, and exited once it crosses above the middle band:
Bollinger Bands can be a great way to trail your stop-loss. Trailing your stop-loss means that the price at which your stop-loss comes into effect adjusts to the current price. When you are using Bollinger Bands, you can set your stop-loss to one of the bands so as to protect yourself against a squeeze or a general increase in volatility.
For example, you can set the Middle or the Lower Bollinger Band as the stop-loss point when you are going long on a stock based on its trend. Conversely, you can use the Middle or the Upper Bollinger Band as your stop-loss when you are going short on a stock currently trending downward. In the image below we get an entry as price crosses under the middle band, and use the lower band as a stop loss:
The important thing with Bollinger Bands is to ascertain your risk level and use them accordingly. If you are someone who has a high appetite for risk and is confident about a particular trade, then you can use either the Lower or the Upper Bollinger Band as your stop-loss point. If you are a conservative investor looking to prevent loss of capital, the Middle band is more likely where you place your stop-loss.
Cons of Bollinger Bands
As we stated above, Bollinger Bands should generally be used with other indicators as they do often not provide enough information about the price movement on their own to be used as an entry signal. John Bollinger, the creator of the Bollinger Band, himself advises against using the Bollinger Band on its own.
Bollinger Bands have many inherent limitations, and we will take you through some of the biggest ones next.
The Simple Moving Average Problem
Bollinger Bands are based on a Simple Moving Average, which presents one of the most obvious problems with the charts. An SMA gives equal weighting to the price of the commodity/instrument 20-days ago as it does to its price yesterday.
In most cases, data from almost three weeks ago will have a far lesser impact on the price than the data from the past week. This means that there is no way to ensure that the data from the Bollinger Bands that is important has not been diluted by data that is largely insignificant.
Standard Settings Dilemma
We have mentioned how the standard Bollinger Band uses a 20-days SMA and 2 standard deviations. However, that may not work for everyone. For example, a more active trader may want to utilize a Bollinger Band which deviates less and/or utilizes a lesser number of periods (thus generating more signals for the trader).
On the contrary, a long-term trader may be looking for a general trend as opposed to a short-term trend and may end utilizing a Bollinger Band with more periods. This means that you will need to adjust Bollinger Bands to coincide with the type of instrument that you are trading. What this also means is that many traders will fail to calibrate their Bollinger Bands properly and thus run into problems.
We recommend that beginners use the standard Bollinger Band as it is bound to work in most situations.
Bollinger Bands are Lagging
Anyone who uses Bollinger Bands can see that the bands only react to the price movements. They do not predict the future price in any way. As such, there is no set formula upon which you can base your predictions and you must devise your own strategy for reacting to the changes in the Bollinger Bands.
Once you couple this with the aforementioned fact that all the periods in an SMA are equally weighted, it is quite obvious to see that Bollinger Bands would have limited use in extremely speculative markets as the price would depend more upon news and extremely short-term trends as opposed to the price of the last 20-days. Conversely, Bollinger Bands work best when the market is stable and the prices move gradually.