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® typically use a 20 period moving average, where the “period” could be 5 minutes, an hour or a day. By default the upper and lower bands are set two standard deviations above and below the moving average. However, traders can customize both the number of periods in the moving average, as well as the number of deviations.
Figure 1: Bollinger Band® activity over the course of 20 days.
Using Bollinger Bands®
There are many ways to use Bollinger Bands®. Before we discuss how to use them, it’s important to note: when the price touches the upper band, it doesn’t necessarily mean that you should sell. Similarly, when the price touches the lower band, it doesn’t necessarily mean you should 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- you might, instead, prefer to wait and look for chart patterns like the “double bottom,” a “classic M top,” or a “three pushes to high” formation. Let’s talk about these chart patterns more:
A double bottom occurs when there is a fall in price, followed by a rise, followed by another fall that is close to the previous low, and finally another rise.
To identify a double bottom, look for a price that has touched the lower band and wait to see where the next low occurs. A price that reacts and rises close to the middle band, followed by a second low inside the lower band, suggests that the price is positioned for an upward move- a good time for traders to buy.
Without the Bollinger Band®, the stock could look like it is trending down on the second low, especially if the second low is lower than the first. But with the Bollinger Band®, the second low may indicate that the stock could be preparing for an uptrend.
Figure 2: 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 either touches or is outside of the upper band, the price reacts with a rise close to the middle band (the moving average), and the second high touches inside the upper band. 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 signals a sell.
Figure 3: 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 creates a new high outside the upper band; the second push makes a new high and touches the upper band; the third push makes a new high, but within the upper band.
This scenario may be a reliable indicator of decreasing momentum. With it, you may notice there is also decreasing volume.
Figure 4: 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.
Signaling the starts or the ends of trends
Bollinger Bands® can also indicate the end of a strong trend. Strong trends, especially those developing after a breakout of a trading range, will result in an expansion in volatility that will cause the bands to initially move apart, meaning that in a strong uptrend, the lower band will actually move downward in the opposite direction of the new trend. When the lower band turns back up, it can be a signal that the move higher might be over, at least for a while.
Another interesting use of Bollinger Bands® is based on the observation that 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 5: 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, to capture longer moves, you could exit when the stock tags the opposite band (i.e. the lower band if you’re long, or the upper band if you’re short).
Pair with other indicators
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.