Master Bollinger Bands 

What are Bollinger Bands? 

The Bollinger Bands indicator is a technical analysis tool that appears on a chart as three lines tracking the price movement of a stock or financial asset. 

The Middle Line: This is the 20-day Simple Moving Average (SMA) of the stock price, reflecting the average price. 

The Upper and Lower Lines: These represent the limits of price volatility and are known as the upper and lower bands. They are defined by a certain distance (usually two standard deviations) above and below the middle line. 

This indicator tells you whether the current price is high or low relative to its average and its typical volatility. 

How It Works 

The distance between the upper and lower bands varies depending on the stock price’s volatility: 

The more volatile the price, the wider the distance between the bands. 

The more stable the price, the narrower the distance between the bands. 

Traders use these bands to determine when a stock is overvalued (a selling opportunity) or undervalued (a buying opportunity). 

When the price approaches the upper band, the stock is considered overbought, indicating a potential decline soon. 

Conversely, if the price approaches the lower band, the stock is considered oversold, indicating a potential rebound and rise soon. 

The Relationship Between Bollinger Bands and Volatility 

Understanding the relationship between Bollinger Bands and Volatility is your key to mastering this indicator. 

First, what is Volatility? In trading, volatility is used to measure how quickly and how much an asset’s price moves over time. 

There are two levels of volatility: 

High Volatility: Prices move quickly and unpredictably, resulting in large swings in both directions. 

Low Volatility: Prices are more stable and move slowly over time. 

Here’s an example to illustrate volatility: 

Imagine two stocks, A & B, both trading at $100. 

Stock A has low volatility, moving only between $99 and $101 throughout the day. 

Stock B has high volatility, fluctuating between $95 and $105 on the same day. 

Although the average price of both stocks is the same ($100), their volatility levels are completely different. 

This is where Bollinger Bands come in to measure volatility: 

When market volatility increases, the bands widen and diverge to encompass the expanded price range. 

When market volatility decreases, the bands narrow and converge, signaling a potential lull that typically precedes a major upcoming price movement. 

Example to Illustrate Bollinger Bands 

The 2001 chart of Microsoft (MSFT) shows that the Bollinger Bands indicator was slow to confirm the uptrend reversal, waiting until early January when the stock reversed and began to rise. 

However, notice what happened before the indicator confirmed this reversal: 

The stock price moved up from $20 to $24. 

After this spike, the price needed to move between $24 and $25 before the indicator gave a clear signal by crossing the middle line, indicating that the trend had indeed reversed. 

This does not mean the indicator is bad at identifying overbought and oversold conditions, rather, this example alerts you to a pivotal point: Start by identifying simple trends and regular moving averages, then move on to using more complex indicators like Bollinger Bands. 

Remember: Do not rely on just one indicator, and make sure you understand the underlying price action first. 

Components of the Bollinger Bands Indicator 

The Middle Band 

It is the 20-day Simple Moving Average (SMA) of the stock price and serves as the primary trend line. 

If the price consistently moves above this line, it signals bullish strength and momentum. 

If the price consistently moves below this line, it signals bearish pressure. 

The Upper and Lower Bands 

These are drawn at two standard deviations, the upper band above the middle band, and the lower band below it. 

Their function is to act as natural limits for price movement, as approximately 95% of price action occurs within these two bands. Therefore, any breakout or breach beyond these bands is considered a strong, tradable signal. 

What is Standard Deviation? 

This measure is the heart and power of the Bollinger indicator, as it measures how much prices deviate from their average (the middle line). 

The higher the price volatility in the market, the higher the standard deviation, and thus the wider the bands become. 

The lower the price volatility in the market, the lower the standard deviation, and thus the narrower the bands become. 

This is where the significance of this measure lies: it reflects the automatic dynamic adjustment of the Bollinger Bands indicator according to current market conditions, rather than using a fixed range. 

Bollinger Band Squeeze Strategy 

This strategy involves moving from periods of low volatility to periods of high volatility that occur during a market bias. This strategy seeks to predict the next major wave in the market by observing the current calm. 

How It Works 

The power of this strategy lies in its ability to identify potential large movements before most traders notice them. It is designed to recognize an area of increasing pressure during a contraction period and anticipate an imminent expansion. 

How to Identify an Area of Increasing Pressure 

A Bollinger Band Squeeze occurs when the upper and lower bands contract sharply, so that they become very close to the middle line. 

This contraction indicates that the market is experiencing very low volatility and that prices are moving slowly and calmly. 

The strategy is based on the premise that periods of low volatility (calm) are often followed by strong, high-volatility breakouts (large market movements). 

The concept can be likened to a spring: when we compress it (Squeeze), the potential energy inside it increases. When we release it (Breakout), the force of the resulting movement is large. 

How to Trade the Bollinger Squeeze 

• Identify the Quiet Period (Squeeze): 

 Look for an area where the upper and lower Bollinger Bands narrow significantly, much lower than the indicator’s usual range. 

• Wait for a Strong Breakout:  

Do not enter as soon as the price touches either band. Wait for a strong candle to close completely outside the band to confirm the breakout is real and not just a fakeout. 

• Check for a Breakout of Important Support or Resistance:  

For a more reliable signal, verify that the breakout has simultaneously broken an important support or resistance level. 

• Confirm the Breakout with Additional Patterns:  

If chart patterns like triangles or flags form during the squeeze and confirm the breakout, this provides additional confirmation. 

• Monitor Volume:  

If the breakout candle is accompanied by a significant increase in volume, this indicates the price movement is supported by liquidity, which increases the reliability of the breakout. 

Remember: The longer the squeeze period and the narrower the bands, the larger the expected breakout that follows. So, make sure you set further profit targets for the trade. 

Other Technical Indicators Similar to Bollinger Bands 

• Keltner Channels: Similar to Bollinger Bands in their upper and lower bands, but they differ in how they measure the width of these bands (using Average True Range). 

• Moving Average Envelopes: Simpler than Bollinger Bands. They differ because they do not widen and narrowwith changes in market volatility, but remain a fixed distance apart. 

• Donchian Channels: Their bands are drawn based on the highest high and lowest low reached by the price during a defined period. 

• Average True Range (ATR) and Standard Deviation: These two indicators do not plot full bands but focus only on measuring how volatile or calm the market movement is. 

Limitations of Using Bollinger Bands 

• It is a Lagging Indicator: It does not predict price changes but responds to them with a delay. It may inform you of a change in trend or volatility after the move has already begun. 

• It May Generate False Signals: Especially when the market is highly volatile and the bands expand significantly. 

• The Default Settings May Not Suit Everyone: The common settings (20-day SMA and two standard deviations) may not be optimal for all asset types or all timeframes. 

In nutshell  

Despite the power of the Bollinger Bands indicator, like any technical analysis tool, it should not be relied upon alone. 

It is always recommended to use the Bollinger indicator with other technical analysis tools for confirmation, such as Momentum indicators and Volume indicators. 

Visit the ”Education and Analysis“ section of Naqdi to learn more about technical analysis tools and gain timely market insights with financial market experts.