Bollinger Bands® are a popular technical indicators used by traders in all markets, including stocks, futures and currencies. There are a number of uses for Bollinger Bands®, including determining overbought and oversold levels, as a trend following tool, and monitoring for breakouts. There are also some pitfalls of the indicators. In this article, we will address all these areas.
Calculation of Bollinger Bands
Bollinger bands are composed of three lines. One of the more common calculations of Bollinger Bands uses a 20-day simple moving average (SMA) for the middle band. The upper band is calculated by taking the middle band and adding twice the daily standard deviation to that amount. The lower band is calculated by taking the middle band minus two times the daily standard deviation.
The Bollinger Band® formula consists of the following:
BOLU = Upper Bollinger Band®
BOLD = Lower Bollinger Band®
n = Smoothing Period
m = Number of Standard Deviations (SD)
SD = Standard Deviation over Last n Periods Typical Price (TP) = (HI + LO + CL) / 3
BOLU = MA(TP, n) + m * SD[TP, n]
BOLD = MA(TP, n) - m * SD[TP, n]
Overbought and Oversold Strategy
A common strategy is using Bollinger Bands® to identify overbought or oversold market conditions. When the price of the asset breaks below the lower band of the Bollinger Bands®, a trader may enter a long position expecting the price to revert back to the middle band. When the price breaks above the upper band, a trader can short the asset betting on a move back to the middle band. This type of strategy relies on the mean reversion of the price. Mean reversion assumes that, if the price deviates substantially from the mean, it eventually reverts back to the mean price. Bollinger Bands® identify asset prices that have deviated from the mean.
In range-bound markets, this technique works well, as prices travel between the two bands like a bouncing ball. However, Bollinger Bands® don't always give accurate buy and sell signals. During a trend, the trader will constantly be placing trades on the wrong side of the move. To help remedy this, a trader could look at the overall direction of price and then only take trade signals that align the trader with the trend. For example, if the trend is down, only take short positions when the upper band is tagged. The lower band can still be used as an exit, if desired, but a new long position is not opened since that would mean going against the trend. (See also: The Basics of Bollinger Bands®.)
There is another way to trade trends, and that is with Bollinger Band® "bands," meaning plural.
Create Multiple Bands For Greater Insight
As John Bollinger acknowledged: "tags of the bands are just that, tags, not signals."
A tag (or touch) of the upper Bollinger Band® is not in and of itself a sell signal. A tag of the lower Bollinger Band® is not in and of itself a buy signal. Price often can and does "walk the band." In those markets, traders who continuously try to "sell the top" or "buy the bottom" are faced with an excruciating series of stop-outs, or even worse, an ever-mounting floating loss as price moves further and further away from the original entry.
Perhaps a more useful way to trade with Bollinger Bands® is to use them to gauge trends.
At the core, Bollinger Bands® measure deviation. This is the reason why they can be very helpful in diagnosing trend. By generating two sets of Bollinger Bands®, one set using the parameter of "1 standard deviation" and the other using the typical setting of "2 standard deviation," we can look at price in a whole new way. We will call this Bollinger Band® "bands."
In the chart below, we see that whenever price holds between the upper Bollinger Bands® +1 SD and +2 SD away from mean, the trend is up; therefore, we can define that channel as the "buy zone." Conversely, if price channels within Bollinger Bands® –1 SD and –2 SD, it is in the "sell zone." Finally, if price meanders between +1 SD band and –1 SD band, it is essentially in a neutral state, and we can say that it's in "no man's land."
Bollinger Bands® adapt dynamically to price expanding and contracting as volatility increases and decreases. Therefore, the bands naturally widen and narrow in sync with price action, creating a very accurate trending envelope.
A Tool for Trend Traders and Faders
Having established the basic rules for Bollinger Band® "bands," we can now demonstrate how this technical tool can be used by both trend traders who seek to exploit momentum and fade-traders who like to profit from trend exhaustion. Returning to the chart above, we can see how trend traders would position long once price entered the "buy zone." They would then be able to stay in the trade as the Bollinger Band® "bands" encapsulate most of the price action of the massive up-move.
As for an exit point, the answer is different for each individual trader, but one reasonable possibility would be to close the long trade if the candle turned red and more than 75% of its body were below the "buy zone." Using the 75% rule, at that point, price clearly falls out of trend, but why insist that the candle be red? The reason for the second condition is to prevent the trend trader from being "wiggled out" of a trend by a quick probative move to the downside that snaps back to the "buy zone" at the end of the trading period. Note how, in the following chart, the trader is able to stay with the move for most of the uptrend, exiting only when price starts to consolidate at the top of the new range.
Bollinger Band® "bands" can also be a valuable tool for traders who like to exploit trend exhaustion by picking the turn in price. Note, however, that counter-trend trading requires far larger margins of error, as trends will often make several attempts at continuation before reversing.
In the chart below, we see that a fade-trader using Bollinger Band® "bands" will be able to quickly diagnose the first hint of trend weakness. Having seen prices fall out of the trend channel, the fader may decide to make classic use of Bollinger Bands® by shorting the next tag of the upper Bollinger Band®.
As for the stop-loss, putting it just above the swing high will practically assure the trader is stopped out, as the price will often make many probative forays at the recent top as buyers try to extend the trend. Instead, measure the width of the "no man's land" area (distance between +1 and –1 SD) and add it to the upper band. By using the volatility of the market to help set a stop-loss level, the trader avoids getting stopped out and is able to remain in the short trade once the price starts declining.
Bollinger Bands Squeeze Strategy
Another strategy to use with Bollinger Bands® is called a squeeze strategy. A squeeze occurs when the price has been moving aggressively then starts moving sideways in a tight consolidation.
A trader can visually identify when the price of an asset is consolidating because the upper and lower bands get closer together. This means the volatility of the asset has decreased. After a period of consolidation, the price often makes a larger move in either direction, ideally on high volume. Expanding volume on a breakout is a sign that traders are voting with their money that the price will continue to move in the breakout direction.
When the price breaks through the upper or lower band, the trader buys or sells the asset, respectively. A stop-loss is traditionally placed outside the consolidation on the opposite side of the breakout. (For more, see: Profiting From the Bollinger Squeeze.)
Bollinger Versus Keltner
Bollinger Bands® and Keltner Channels are different, but similar, indicators. Here is a brief look at the differences, so you can decide which one you like better.
Bollinger Bands® use standard deviation of the underlying asset, while Keltner Channels use the average true range. Aside from how the bands/channels are created, the interpretation of these indicators is generally the same.
Since Keltner Channels use average true range rather than standard deviation, it is common to see more buy and sell signals generated in Keltner Channels than when using Bollinger Bands®.
One is not better than the other; it is a personal choice based on which works best for the strategies being employed. (See also: Discovering Keltner Channels and the Chaikin Oscillator.)
The Bottom Line
There are multiple uses for Bollinger Bands®, including using them for overbought and oversold trade signals. Traders can also add multiple bands, which helps highlight the strength of the price. Another way to use the bands is to look for volatility contractions. These contractions are typically followed by significant price breakouts, ideally on large volume. Bollinger Bands® should not be confused with Keltner Channels. While the two indicators are similar, they are not exactly alike.