Table of Contents
Table of Contents

The Basics of Bollinger Bands®

In the 1980s, John Bollinger, a long-time technician of the markets, developed the technique of using a moving average with two trading bands above and below it. Unlike a percentage calculation from a normal moving average, Bollinger Bands® simply add and subtract a standard deviation calculation.

Key Takeaways

  • Bollinger Bands® consist of a centerline and two price channels or bands above and below it.
  • The centerline is typically a simple moving average while the price channels are standard deviations of the stock being studied.
  • The bands expand and contract as price action becomes volatile (expansion) or bound into a tight trading pattern (contraction).
  • Traders designate the upper and lower bands as price targets when drawing the bands.
  • When the price continually touches the upper Bollinger Band, it can indicate an overbought signal while continually touching the lower band indicates an oversold signal.

Understanding Bollinger Bands

Understanding Bollinger Bands®

Bollinger Bands® consist of a centerline and two price channels or bands above and below it. The centerline is typically a simple moving average while the price channels are the standard deviations of the stock being studied. The bands expand and contract as the price action of an issue becomes volatile (expansion) or becomes bound into a tight trading pattern (contraction).

A stock may trade for long periods in a trend, albeit with some volatility from time to time. To better see the trend, traders use the moving average to filter the price action. This way, they can gather important information about how the market is moving. For example, after a sharp rise or fall in the trend, the market may consolidate, trading in a narrow fashion and crisscrossing above and below the moving average. To better monitor this behavior, traders use the price channels, which encompass the trading activity around the trend.

We know that markets trade erratically on a daily basis even though they are still trading in an uptrend or downtrend. Technicians use moving averages with support and resistance lines to anticipate the price action of a stock.

Technical analysis is a trading strategy that analyzes statistical trends to identify trading opportunities.

Drawing the Lines

Upper resistance and lower support lines are first drawn and then extrapolated to form channels within which the trader expects prices to be contained. Some traders draw straight lines connecting either tops or bottoms of prices to identify the upper or lower price extremes, respectively, and then add parallel lines to define the channel within which the prices should move. As long as prices do not move out of this channel, the trader can be reasonably confident that prices are moving as expected.

When stock prices continually touch the upper Bollinger Band®, the prices are thought to be overbought; conversely, when they continually touch the lower band, prices are thought to be oversold, triggering a buy signal.

When using Bollinger Bands®, designate the upper and lower bands as price targets. If the price deflects off the lower band and crosses above the 20-day average (the middle line), the upper band comes to represent the upper price target. In a strong uptrend, prices usually fluctuate between the upper band and the 20-day moving average. When that happens, a cross below the 20-day moving average warns of a trend reversal to the downside.

Examples of Bollinger Bands®

The chart below is of American Express (AXP) from the start of 2008. You can see that for the most part, the price action was touching the lower band and the stock price fell from the $60 level in the dead of winter to its March position of around $10. In a couple of instances, the price action cut through the centerline (March to May and again in July and August), but for many traders, this was certainly not a buy signal as the trend wasn't broken.

Image by Sabrina Jiang © Investopedia 2020 

In the 2001 chart of Microsoft (MSFT) below, you can see the trend reversed to an uptrend in the early part of January. But take a look at how slow it was in showing the trend change. Before the price action crossed over the centerline, the stock price moved from $20 to $24 and then on to between $24 and $25 before some traders would have confirmation of this trend reversal.

Image by Sabrina Jiang © Investopedia 2020

This is not to say that Bollinger Bands® aren't a well-regarded indicator of overbought or oversold issues, but charts like the 2001 Microsoft layout are a good reminder that we should start out by recognizing trends and simple moving averages before moving on to more exotic indicators.

What Are Bollinger Bands®?

Bollinger Bands® are tools used in technical analysis. They were designed by John Bollinger, a technical trader. The bands are used to generate signals for securities that are oversold or overbought. The bands are composed of different lines that are plotted on a chart, including the moving average, an upper band, and a lower band.

What Do Bollinger Bands® Tell You?

Bollinger Bands® are highly technical tools that give traders an idea of where the market is moving based on prices. It involves the use of three bands—one for the upper level, another for the lower level, and the third for the moving average. When prices move closer to the upper band, it indicates that the market may be overbought. Conversely, the market may be oversold when prices end up moving closer to the lower or bottom band.

Are There Any Limitations to Bollinger Bands®?

Yes. One of the main limitations is that it shouldn't be used as a standalone tool. In fact, Bollinger Bands® should be used with other non-correlated indicators. Doing so may give you additional market signals that are much more direct. Another drawback is that they are calculated using a simple moving average. That's because older price data is weighted in the same way as recent data.

The Bottom Line

While every strategy has its drawbacks, Bollinger Bands® are among the most useful and commonly used tools in spotlighting extreme short-term security prices. Buying when stock prices cross below the lower Bollinger Band® often helps traders take advantage of oversold conditions and profit when the stock price moves back up toward the center moving-average line.

Article Sources
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