Bollinger Bands: Studying Stock Prices on Bollinger Band Charts

Bollinger Bands depict a simple moving average (or SMA) for twenty days of closing price data, as well as the higher and lower parameters to which these price changes could fluctuate. Investors and financial analysts use these bands as trading signals to assess the effect of high or low volatility on various stock prices.

The technical analysis tool gets its name from creator John Bollinger. They operate similar to Keltner channels in that they envelop the averages of price data (represented by a middle line) with an upper ceiling and lower floor for potential price movements (represented by the upper and lower Bollinger Bands).

Bollinger Bands are tools that help traders make sense of fluctuating price movements. These tools work by:

• Assessing price volatility: 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 squeeze tightly around the average line, it signals volatility increases are on the horizon. Sometimes the average might even go beyond the upper and lower parameters, in which case a breakout occurs. This indicates an exceptional degree of unpredictability.
• Informing trading decisions: By measuring Bollinger Band width, you can make more informed trading decisions. When the SMA line hews close toward the lower band, it indicates a downtrend is likely to persist for the security price. Conversely, when it hews closer to the upper band, an uptrend is in the cards. This can help investors decide when to go all in or when to pull back on their trading.
• Pairing with other trading tools: Bollinger Bands are more helpful as one tool in a wider arsenal, as opposed to a singular foundation for your buying and selling strategies. Pair Bollinger Bands with the relative strength index (RSI), the moving average convergence divergence (MACD) technical indicator, and candlestick pattern analysis to build out a more holistic strategy.

Bollinger Bands operate off of basic statistical principles. Learn how to calculate Bollinger Bands to better inform your trading strategies and decisions.

• Average out twenty days of data. Collect for twenty days the closing prices of the stock you wish to analyze. While you can shorten or extend this time frame for your analysis, twenty days is the traditional amount John Bollinger himself suggested. Add these totals up and divide them repeatedly to create the middle band of your diagram based on the standard moving average (or SMA).
• Calculate standard deviations. To lay the groundwork for creating the higher and lower bands, you’ll need to calculate both a positive and negative standard deviation. Though you could technically calculate any number of standard deviations, Bollinger Bands only represent the nearest higher and lower ones in comparison to your SMA. To do so, take the square root of the variance in your diagram.
• Create the bands themselves. Now that you have your standard deviations, multiply them both by two. For the upper Bollinger Band, add this sum to each point of your standard moving average. For the lower, subtract the sum. These will allow you to pinpoint the parameters on the top and bottom sides of your price data. See if you can detect strong trends in the information now that you’ve created a visual representation of your trading system.

Despite their strengths, Bollinger Bands have their share of weaknesses. A heavy reliance on Bollinger Bands can cause your trading strategy to fall short. This is because Bollinger Bands:

1. 1. Emphasize older data. Bollinger Bands only classify information retroactively. They look over a previous period of twenty days to make sense of price moves. As a result, it’s difficult to use them to accommodate any new highs or lows in your pricing data.
2. 2. Fall short of total accuracy. The Bollinger Band approach does a pretty good job of depicting price volatility, but as with any other financial tool, it’s not one hundred percent accurate. It only takes in data for a short time frame. On top of that, a host of extraneous factors can cause prices to fluctuate beyond the parameters the bands indicate. Exercise caution as you would with any financial decision or strategy.
3. 3. Use arbitrary metrics: There’s no solid scientific or mathematical principle underlying why Bollinger Band indicators should cover a twenty-day period. While standard deviations are useful, they don’t reliably enclose all potential price fluctuations. These arbitrary metrics can make it difficult for you to make sense of trend reversals, anomalies, and abnormalities.

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