What Are Bollinger Bands?
Bollinger Bands are a type of technical analysis tool defining the prices and volatility over a period of time of a financial instrument using a formulaic method developed by John Bollinger in the 1980s.
Bollinger Bands displays a set of trendlines plotted two standard deviations apart from a simple moving average (SMA) of a security’s price, but which can be modified according to its user’s preferences. Financial analysts and traders employ these charts as an analytical tool to implicate trading decisions or control automated trading systems.
The goal of Bollinger Bands is to render a relevant definition of high and low prices of a stock or other financial instruments. By its definition, prices of stocks are high at the upper band and low at the lower band, which makes it a lagging indicator.
How To Calculate Bollinger Bands
Generally, traders and analysts use a 20-period moving average. So to calculate Bollinger Bands, you need to calculate the 20-period simple moving average. A 20-period moving average would equalize the closing prices for the first 20 periods as the initial data point.
The next data point would cut the earliest price and add the price on the 21st period and take the average, and so on. Resulting standard deviation of the security’s price will be obtained.
The standard deviation measures how to separate out numbers are from an average price. Standard deviation can be computed by taking the square root of the variance, which itself is the mean of the squared variations of the mean.
The next step is to multiply the standard deviation value by two and both add and subtract that amount from each point along the SMA. Resultant produce the upper and lower bands.
Formula To Calculate Bollinger Bands
- Middle Band = 20-Period simple moving average (SMA)
- Upper Band = 20-Period SMA + (20-day standard deviation of price x 2)
- Lower Band = 20-Period SMA – (20-day standard deviation of price x 2)
Understanding The Bollinger Bands
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Bollinger Bands consists of a central line and two price bands above and below it. The central line is a simple moving average (SMA) and the price bands are the standard deviations of the financial instrument. The bands will grow and shrink according to the price action and volatility. When volatility increases the price bands grow and with a decrease in volatility the price bands shrink.
As we know that markets trade unevenly on a daily basis, though they are yet trading in an uptrend or downtrend. So technical analysts use moving averages with supports and resistance lines. The upper resistance and lower support lines are first drawn and then envisioned to form bands within which the analysts expect prices to be range-bound.
John Bollinger has set several rules to follow when using this tool.
Although Bollinger bands are an important tool for traders and analysts, there are a few flaws that traders should not ignore before using them. The biggest limitation of Bolliger bands is, it is reactive rather than predictive. The price moves either uptrends or downtrends, but will not predict the future price. Like most other technical indicators, Bollinger Bands are also lagging indicators.
Another flaw of Bollinger Bands is that the default settings of the period will not work for all types of traders and financial instruments. Also, the effectiveness of Bollinger Bands changes from one market to another, and traders may need to adjust the period even if they are trading the same stock over a period of time.
Every technical analysis tool has its limitations, Bollinger Bands is one of the most helpful and used technical indicators used by traders. As you know it is a lagging indicator that means traders enter a stock after hitting a lower band and exit after touching the upper band. Overall, it is one of the greatest tools ever invented.