Flexible and visually intuitive to many traders, Bollinger Bands can be a helpful technical analysis tool. Invented in 1983 by John Bollinger, they’re designed to help traders evaluate price action and a stock’s volatility.
Before we get to how they can do that, let’s talk about what they are and what they look like. A Bollinger Band consists of a middle band (which is a moving average) and an upper and lower band. These upper and lower bands are set above and below the moving average by a certain number of standard deviations of price, thus incorporating volatility. The general principle is that by comparing a stock’s position relative to the bands, a trader may be able to determine if a stock’s price is relatively low or relatively high. Further, the width of the band can be an indicator of its volatility (narrower bands indicate less volatility while wider ones indicate higher volatility).
Bollinger Bands are typically charted over 20 “periods.” Some traders make those periods days, other traders prefer a shorter-term look and they make the periods hours. In addition, the default is that the upper and lower bands are set two standard deviations above and below the price. However, it doesn’t have to be 20 periods, and it should be noted that many traders will decrease the standard deviation when charting less than 20 periods, and increase the deviation when charting more than 20 periods.
Figure 1: Bollinger Band activity over the course of 20 days.
Using Bollinger Bands
There are many ways to use Bollinger Bands. But it’s important to note that when the price touches the upper band, that doesn’t automatically mean sell. Similarly, if the price touches the lower band, that doesn’t necessarily mean buy. In fact, take it from John Bollinger himself who said, "There is absolutely nothing about a tag of a band that in and of itself is a signal."
Prices can “walk the band” during a strong down- or uptrend. This means that there are repeated instances of a price touching or breaking through the lower or upper band. That’s why you may not want to take action when the price touches either band, and might, instead, prefer to wait to look for a “double bottom,” a “classic M top,” or a “three pushes to high” formation.
Figure 2: Several examples of the price touching the top or bottom band over a 6-month period
With a double bottom, you note the first time the price touches the lower band and then wait to see where the next low occurs relative to the band. (Remember, a price that’s at or near the low could indicate a buy signal). In a double bottom scenario, a trader may have higher odds of success if the first low is touching or outside the lower band, then the price reacts and rises close to the middle band, and then the second low is inside the lower band.
The second low may be higher or lower than the first low. But if the second low is within the lower band (even if it is lower than the first low), there is a double bottom, which may give traders more confidence buying on the second low. In other words, in this case, without the Bollinger Band, the stock could look like it is trending down on the second low. But with The Bollinger Band, the second low may indicate a good time to buy, as the stock could be preparing for an uptrend.
Figure 3: The double bottom on display.
The classic M top
The classic M top is formed by a push to a high, followed by sell off reaction, and then a test of the previous high. The second high can be higher or lower than the first high. Watching the price behave like this, a trader may wonder if the stock is in a new uptrend, or if it has met its resistance. The Bollinger Band may help to answer this.
In a Classic M Top, the first high is touching or outside the upper band, the reaction gets close to the middle band (the moving average); and the second high is inside the upper band. And again, the second high can be higher or lower than the first high. The fact that the second high is within the upper band suggests that it is a lower high on a relative basis. For many traders, this second high then signals a sell.
Figure 4: This Classic M Top shows how a second high can be both higher than the first, yet still within the upper band.
Three pushes to high
A "three pushes to high" top often develops as a leading edge of a larger, longer topping formation. Typically the way it forms is like this: the first push will make a new high outside the upper band; the second push will make a new high and touch the upper band; the third push will make a new high, but will be within the upper band.
That may be a reliable indicator of decreasing momentum. With it, you may notice there is also decreasing volume.
Figure 5: With the first high above the upper band, the second high at it, and the third high beneath the upper band, the Three Pushes To High formation is complete.
Walking the bands
This bears repeating: just because a price touches an upper or lower band, it does not necessarily mean there is a signal. A mistake some traders make is that they treat any tag of the band as a trigger. But actually, in a sustained uptrend, there will be repeated touches of the upper band, and vice-versa: in a sustained downtrend there may be repeated touches of the lower band with some closes below it in a decline; this is called walking the bands.
Signaling the starts or the ends of trends
Bollinger Bands can also indicate the ends of strong trends. Strong trends cause an expansion in volatility that will cause the bands to initially move apart, meaning the lower band will actually move down opposite the trend. When a trend begins to wane, the lower band in an uptrend will turn back up, which can be a signal that the move might be over (at least for a while).
Volatility tends to be “mean reverting”: periods of low volatility are generally followed by high volatility and vice versa.
When the bands are narrow it is called a “squeeze,” and it means that volatility is low. But remember, since volatility is mean reverting, the bands will probably expand, signaling a potential for an explosive move. A simple way to spot a squeeze is when the bands are the narrowest they have been for the last six months.
Figure 6: The Bollinger Band shows a “squeeze,” which could signal more volatility ahead.
When trading a squeeze, you might consider placing a buy entry point above the upper band, or a sell entry point below the lower band in the squeeze area. For buys, consider placing an initial stop under the low of the breakout formation or under the lower band. For sells, consider placing your initial stop over the high of the breakout formation or over the upper band. Then, to exit the trade, consider using a trailing stop: a fixed dollar fixed percentage or parabolic SAR.
Or another exit strategy (to capture longer moves) could be to exit when the stock tags the opposite band (i.e. the lower band if you’re long, or the upper band if you’re shorting).
As you can see, Bollinger Bands can be useful by themselves. But, remember too that they can also be combined with other indicators. Since they are a pure price indicator, you might want to consider combining them with volume indicators for even more depth and insight. Ultimately, there’s no indicator that guarantees you’ll always get in at the bottom or out at the top. However, Bollinger Bands—especially when paired with other indicators such as chart pattern recognition tools—can help you make better trading decisions.