Bollinger Bands depict the price action of a security between a set of high and low parameters over a given time period. These enable investors to more accurately calculate how volatile a particular stock has become, as well as whether other investors have been overbuying or overselling it. Learn how to use Bollinger Bands to better understand the stocks in your own portfolio.
What Are Bollinger Bands?
Bollinger Bands depict a simple moving average (or SMA) for the previous twenty days of closing price data, as well as the upper and lower parameters within which these price changes may fluctuate. These bands are used as trading signals by investors and financial analysts to assess the impact of high or low volatility on various stock prices.
The technical analysis tool was named after its creator, John Bollinger. They function similarly to Keltner channels in that they envelop price data averages (represented by a middle line) with an upper and lower ceiling for potential price movements (represented by the upper and lower Bollinger Bands).
How Do Bollinger Bands Work?
Bollinger Bands are tools that help traders make sense of price fluctuations. These tools function as follows:
1. The distance between the SMA line and either the upper or lower bands indicates the level of volatility in the security price. For example, when the Bollinger Bands constrict tightly around the average line, it indicates that volatility is on the rise. The average may occasionally exceed the upper and lower parameters, resulting in a breakout. This indicates a high level of unpredictability.
2. Making more informed trading decisions: By measuring Bollinger Band width, you can make better trading decisions. When the SMA line approaches the lower band, it indicates that the security price is likely to remain in a downtrend. When it gets closer to the upper band, an uptrend is on the way. This can assist investors in determining when to go all in or when to scale back on their trading.
3. Combination with other trading tools: Bollinger Bands are more useful as one tool in a larger arsenal than as a sole foundation for your buying and selling strategies. To create a more comprehensive strategy, combine Bollinger Bands with the relative strength index (RSI), the moving average convergence divergence (MACD) technical indicator, and candlestick pattern analysis.
How to Calculate Bollinger Bands
Bollinger Bands are based on fundamental statistical principles. Learn how to calculate Bollinger Bands to help you make better trading decisions.
1. Take the average of the last twenty days of data. Collect the closing prices of the stock you want to analyze for the next twenty days. While you can shorten or lengthen this time frame for your analysis, John Bollinger himself recommended twenty days. Add these totals together and divide them again and again to get the middle band of your diagram based on the standard moving average (or SMA).
2. Determine the standard deviations. Calculate both a positive and negative standard deviation to lay the groundwork for creating the upper and lower bands. Though technically any number of standard deviations could be calculated, Bollinger Bands only represent the ones that are closest to your SMA in terms of higher and lower bounds. Take the square root of the variance in your diagram to do so.
3. Make the bands yourself. Multiply your standard deviations by two now that you have them. Add this sum to each point of your standard moving average to get the upper Bollinger Band. Subtract the sum from the lower. These will allow you to zero in on the parameters at the top and bottom of your price data. Now that you've created a visual representation of your trading system, see if you can spot any strong trends in the data.
3 Limitations of Bollinger Bands
Despite their advantages, Bollinger Bands have some drawbacks. Your trading strategy may fall short if you rely too heavily on Bollinger Bands. This is due to Bollinger Bands:
1. Highlight older data. Bollinger Bands only classify information in the past. They examine the previous twenty days to make sense of price movements. As a result, using them to accommodate any new highs or lows in your pricing data is difficult.
2. Fail to achieve complete accuracy. The Bollinger Band approach does a good job of depicting price volatility, but like any other financial tool, it is not perfect. It only accepts data for a short period of time. Furthermore, a variety of unrelated factors can cause prices to deviate from the parameters indicated by the bands. As with any financial decision or strategy, proceed with caution.
3. Use of arbitrary metrics: There is no scientific or mathematical reason why Bollinger Band indicators should cover a twenty-day period. While standard deviations are useful, they do not consistently encompass all potential price fluctuations. These arbitrary metrics can make understanding trend reversals, anomalies, and abnormalities difficult.