Whether you’re trading stocks on Wall Street or currencies on the forex market, one of the first things you learn is that technical analysis is king. Trading in financial markets is all about predicting price movements — an impossible task without the right tools.
The most successful traders use a wide range of technical analysis tools to decode patterns on price charts and find profitable opportunities in the market.
One trading tool most big-league traders have in their toolbox is known as Bollinger Bands. John Bollinger, a famous technical trader, developed the tool in the 1980s and later trademarked it. The tool remains a top choice among technical traders today, more than three decades after its introduction.
What Are Bollinger Bands?
Bollinger Bands are a technical analysis system short-term traders use to measure price volatility and identify overbought and oversold conditions across a wide range of financial assets. The tool is an oscillator, meaning it’s composed of three lines:
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- The Upper Band. The upper band is created by taking positive standard deviations from a simple moving average (SMA) of the stock price. The SMA is a moving average of the asset’s closing prices. Traders typically consider the upper band to be two standard deviations from the 20-period SMA, but the number of periods and standard deviations can be adjusted to fit your needs.
- The Middle Band. The middle band, also known as the middle line or trendline, is the 20-period SMA of the asset’s price and always stays in the range between the upper and lower bands. Again, traders typically use a 20-period SMA, but you can adjust this to fit your preferences.
- The Lower Band. The lower band is created by taking negative standard deviations from the SMA. Traders typically use two standard deviations, but this too can be adjusted. However, it’s important to use the same number of standard deviations to create both the upper and lower bands.
That’s a lot to take in, especially if you’re a beginner. Don’t worry; you’ll never actually have to calculate the SMA or standard deviations. You can simply click a button to add Bollinger Bands to most interactive trading charts.
How Bollinger Bands Work
Bollinger Bands are a momentum oscillator, which means they work by creating a middle line that oscillates between two extremes. As the signal line in the oscillator nears each extreme, it tells the investor something new. Bollinger Bands are unique in that both the extremes and the price movement behind them each tell their own stories.
The extremes on Bollinger Bands are based on standard deviations, which are a measure of volatility. When market volatility increases, the two outer bands stretch far away from each other. This is a sign that volatility is high and will likely cool relatively soon. On the other hand, when the two outer bands are close to each other, it’s a signal that the asset is going through a period of low volatility, which are typically followed by periods of higher volatility filled with opportunities.
Traders also use Bollinger Bands to determine if financial assets are in overbought or oversold conditions. When the trendline, the price of the stock, or both come close to the upper band, traders believe the stock is overbought and due for a pullback. When these signals come close to the lower band, traders believe the stock is oversold and could climb in value soon.
Assets typically trade in the range between the upper and lower bands about 90% of the time. When the price of the asset breaches the upper or lower band, traders call the move a breakout. Breakouts are significant events because they mean the asset is either extremely overbought (breaks above the upper band) or extremely oversold (breaks below the bottom band).
Pros & Cons of Bollinger Bands
Trading is an attempt at predicting the future, which is impossible to do accurately 100% of the time, regardless of the tools you use. As such, any technical indicator, including Bollinger Bands, comes with its own set of pros and cons; this is why most successful traders use a multiple indicators as they trade.
Pros
Bollinger Bands might really be the best thing since sliced bread, at least for technical traders. It’s an easy-to-use tool that’s highly effective in pointing out potential opportunities. Here’s why most successful traders use Bollinger Bands:
- Accurate Measure of Volatility. Bollinger Bands are arguably the most accurate technical indicator in terms of measuring and predicting volatility. Because traders exploit market fluctuations for profits, knowing when those fluctuations are coming is crucial.
- Simple. It’s not hard to spot patterns when you use Bollinger Bands. Although there are some advanced trading strategies you can use them for, most signals are easy to spot, even if you’re a beginner.
- Readings on Support and Resistance. The indicator is also relatively accurate in signaling overbought and oversold conditions, making it a great tool for confirming support and resistance levels.
Cons
There are plenty of reasons to add Bollinger Bands to your toolbox, but it isn’t perfect. There are a few limitations you should be aware of before using Bollinger Bands to trade.
- Not a Standalone System. John Bollinger didn’t design Bollinger Bands to be a standalone indicator. The system was designed to be used in conjunction with other technical indicators like the moving average convergence divergence (MACD) and the relative strength index (RSI).
- Misunderstood Signals. When the outer bands close in on each other, it’s a signal that volatility is coming, but it’s not a directional signal. Many beginners see this signal and take long positions only to be hammered by downward price movement. Breakouts are also often misunderstood as directional, leading to losses among beginners. The only directional signals the indicator provides are overbought and oversold signals, which should be verified using other indicators.
- Delayed Results. Some experts argue that Bollinger Bands are often late to signal coming price movements. As a result, it may be best for swing traders who want to get in on the middle of the trend, rather than position traders who want to take advantage of a trend from beginning to end.
Should You Use Bollinger Bands?
No tool in financial markets is a one-size-fits-all solution. Bollinger Bands were developed for a specific type of market participant. They may be perfect for your toolbox if:
- You’re a Day Trader. The tool is best if you’re a trader who wants to exploit short-term price movements. If you’re a long-term investor or a position trader, this isn’t the most effective tool for you.
- You’re a Swing Trader. The indicator is perfect for you if you’re a swing trader because it makes visualizing volatility easy to do at a glance. As a swing trader, you want to dive in as price action heats up and get out before it cools down completely. There’s no better indicator for determining these entries and exits.
- You’re Comfortable Using Multiple Indicators. Most technical indicators are best when paired with others for validation, but Bollinger Bands take that a step further. John Bollinger himself has said the tool was designed to be combined with two or three other indicators to provide solid trading signals. If you’re a single-indicator trader and too much information on your chart drives you insane, Bollinger Bands aren’t for you.
How to Use Bollinger Bands
The best way to use this technical indicator is as a way to determine if price movements will speed up or decrease ahead. Then use other indicators to verify your findings and determine the direction of those price movements.
Squeeze
A squeeze takes place when the two outer bands get close to each other. It means price action has slowed down to a crawl and is often a signal that movement will pick up in a big way ahead.
When you see a squeeze, use other indicators to determine the direction of the coming movement and prepare to take advantage of the opportunity.
You can also look for the opposite of a squeeze when you have an open trade going. As the outer bands widen, price action is speeding up. When they reach their widest point and begin to narrow, it signals price action is slowing, which could be a sign to exit your trade.
Overbought/Oversold Strategy
When you find stocks in overbought (overvalued) or oversold (undervalued) territory, you’ve found a sign that a trend reversal is coming. Overbought conditions point to a pullback, while oversold conditions mean upward movement is generally ahead.
When the price of the financial asset nears the upper band, the asset is in overbought territory and it may be time to sell. If it nears the lower band, it’s in oversold territory and it may be time to buy. However, as Bollinger suggests, you should use other indicators to verify your findings before acting upon them.
Breakout
Breakouts happen when the price of a financial asset breaches the upper or lower band. Most financial assets will only spend about 10% of the time outside of these ranges, but when they do, it’s generally a sign of significant volatility to come.
The problem is that traders often see these breakouts as trading signals, with the idea that when the price moves above the upper band, big declines are on the horizon (and the opposite with the lower Bollinger Band).
These breakouts are significant events often followed by an uptrend or downtrend, but determining which direction will follow a breakout without the use of other indicators — and potentially fundamental data — may be impossible.
For example, you might notice the price of a stock broke below the lower band, so you load up on it. After all, it must be significantly oversold and a big upward move is coming, right? You later find the stock undergoing a significant correction after management missed earnings and revenue expectations and cut guidance for future quarters in half.
These kinds of things happen all the time, and they take countless victims when they do. Don’t be one of the victims. Treat a breakout as nothing more than a signal of volatility to come, and use other tools to determine the direction of the future price movement.
Bollinger Bands FAQs
Bollinger Bands are relatively simple once you start using them, but until you do, they may seem pretty complex. It’s not surprising that beginners often have questions about using this trading tool. If you have a few questions of your own, chances are you’ll find the answers below.
What Technical Indicator Works Best With Bollinger Bands?
John Bollinger said you should use two or three other technical indicators in conjunction with Bollinger Bands to verify your findings. In particular, these indicators should use a different set of data or use the data in a different way.
Two of his favorite indicators to use with the bands that bear his name are the relative strength index (RSI) and moving average convergence divergence (MACD). These are popular indicators that are available on most stock charts.
Are Bollinger Bands Good for Day Trading?
Bollinger Bands are a popular tool among day traders, but using them alone is risky business. Always remember to verify your findings with data from other technical indicators. Bollinger Bands are an even better fit for swing traders who prefer to wait for trends to become clearly defined before jumping into a trade.
What Time Frame Is Best for Bollinger Bands?
Traditionally, traders use a 20-period time frame. However, the time frame that’s best for you depends on your trading style and unique needs. If you need to see averages over the long run, simply increase the time period. If you’re looking for short-term opportunities, you can decrease the time frame.
Final Word
Bollinger Bands are a useful tool that most traders should learn to use, with the exception of position traders. However, John Bollinger was clear about the uses and limitations of his trading system when he introduced it. He even put together a list of 22 rules that should be followed when using it.
I strongly recommend getting to know those rules.
Nonetheless, when you use them properly, there’s no question about the value that Bollinger Bands add to any short- to mid-term trading strategy.