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Bollinger Bands
Bollinger Bands, a chart indicator developed by John Bollinger, are used to measure a market's volatility. Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract and when the market is LOUD, the bands expand. Notice on the chart below that when price is quiet, the bands are close together. When price moves up, the bands spread apart.
That's all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger Band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn't feel like typing it all out. In all honesty, you don't need to know any of that junk. We think it's more important that we show you some ways you can apply the Bollinger Bands to your trading.
Note: If you really want to learn about the calculations of a Bollinger Band, then you can go to
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce. By looking at the chart below, can you tell us where the price might go next?
If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.
What you just saw was a classic Bollinger bounce. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels. The longer the time frame you are in, the stronger these bands tend to be. Many traders have developed systems that thrive on these bounces and this strategy is best used when the market is ranging and there is no clear trend.
Now let's look at a way to use Bollinger Bands when the market does trend.
Bollinger Squeeze
The Bollinger squeeze is pretty self-explanatory. When the bands squeeze together, it usually means that a breakout is getting ready to happen. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then price will usually continue to go down.
Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?
If you said up, you are correct again! This is how a typical Bollinger squeeze works. This strategy is designed for you to catch a move as early as possible. Setups like these don't occur every day, but you can probably spot them a few times a week if you are looking at a 15-minute chart. There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them. It's time to put this in your trader's toolbox.
The middle band reflects an intermediate-term trend. The 20 day - simple moving average (SMA) usually serves this purpose.
The upper band is the same as the middle band, but it is shifted up by two standard deviations, a formula that measures volatility, showing how the price can vary from its true value
The lower band is the same as the middle band, but it is shifted down by two standard deviations to adjust for market volatility.
Bollinger Bands establish a Bandwidth, a relative measure of the width of the bands, and a measure of where the last price is in relation to the bands.
Upper Bollinger Band = SMA + 2 standard deviations.
Signals: Overbought/Oversold
%B can be used to identify overbought and oversold situations. However, it is important to know when to look for overbought readings and when to look for oversold readings. As with most momentum oscillators, it is best to look for short-term oversold situations when the medium-term trend is up and short-term overbought situations when the medium-term trend is down. In other words, look for opportunities in the direction of the bigger trend, such as a pullback within a bigger uptrend. Define the bigger trend before looking for overbought or oversold readings.
Chart below shows within a strong uptrend. Notice how %B moved above 1 several times, but did not even come close to 0. Even though %B moved above 1 numerous times, these "overbought" readings did not produce good sell signals. Pullbacks were shallow as stock reversed well above the lower band and resumed its uptrend. John Bollinger refers to "walking the band" during strong trends. In a strong uptrend, prices can walk up the upper band and rarely touch the lower band. Conversely, prices can walk down the lower band and rarely touch the upper band in a strong downtrend.
After identifying a bigger up trend, %B can be considered oversold when it moves to zero or below. Remember, %B moves to zero when price hits the lower band and below zero when price moves below the lower band. This represents a move that is 2 standard deviations below the 20-day moving average. Below chart shows within an uptrend that began in March 2009. %B moved below zero three times during this uptrend. The oversold readings in early July and late October provided good entry points to partake in the bigger uptrend.
Signals: Trend Identification
John Bollinger's book also featured a trend-following system using %B with the Money Force Index, also known as the Money Flow Index (MFI). An uptrend begins when %B is above .80 and MFI is above 80. MFI is bound between zero and a hundred. A move above 80 places MFI in the upper 20% of its range, which is a strong reading. Bollinger suggested setting MFI periods at 1/2 the number of Bollinger Band periods, which would be 10. Downtrends are identified when %B is below .20 and MFI is below 20.
Chart below shows with Bollinger Bands (20,2), %B and MFI (10). An uptrend started in late July when %B was above .80 and MFI was above 80. This uptrend was subsequently affirmed with two more signals in early September and mid November. While these signals were good for trend identification, traders would likely have had issues with the risk-reward ratio after such big moves. It takes a substantial price surge to push %B above .80 and MFI above 80 at the same time. Traders might consider using this method to identify the trend and then look for appropriate overbought or oversold levels for better entry points.
Conclusions
%B quantifies the relationship between price and Bollinger Bands. Readings above .80 indicate that price is near the upper band. Readings below .20 indicate that price is near the lower band. Surges towards upper band show strength, but can sometimes be interpreted as overbought. Plunges to the lower band show weakness, but can sometimes be interpreted as oversold. A lot depends on the underlying trend and other indicators. While %B can have some value on its own, it is best when used in conjunction with other indicators or price analysis.
One of the great joys of having invented an analytical technique such as Bollinger Bands is seeing what other people do with it. The following rules covering the use of Bollinger Bands were gleaned from the questions users have asked most often and our experience over 25 years of using the bands. While there are many ways to use Bollinger Bands, these rules should serve as a good beginning point.
1. Bollinger Bands provide a relative definition of high and low. By definition price is high at the upper band and low at the lower band.
2. That relative definition can be used to compare price action and indicator action to arrive at rigorous buy and sell decisions.
3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc.
4. If more than one indicator is used the indicators should not be directly related to one another. For example, a momentum indicator might complement a volume indicator successfully, but two momentum indicators aren't better than one.
5. Bollinger Bands can be used in pattern recognition to define/clarify pure price patterns such as "M" tops and "W" bottoms, momentum shifts, etc.
6. Tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.
7. In trending markets price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.
8. Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.)
9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the width of the bands are just that, defaults. The actual parameters needed for any given market/task may be different.
10. The average deployed as the middle Bollinger Band should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.
11. For consistent price containment: If the average is lengthened the number of standard deviations needs to be increased; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced; from 2 at 20 periods, to 1.9 at 10 periods.
12. Traditional Bollinger Bands are based upon a simple moving average. This is because a simple average is used in the standard deviation calculation and we wish to be logically consistent.
13. Exponential Bollinger Bands eliminate sudden changes in the width of the bands caused by large price changes exiting the back of the calculation window. Exponential averages must be used for BOTH the middle band and in the calculation of standard deviation.
14. Make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The distribution of security prices is non-normal and the typical sample size in most deployments of Bollinger Bands is too small for statistical significance. (In practice we typically find 90%, not 95%, of the data inside Bollinger Bands with the default parameters)
15. %b tells us where we are in relation to the Bollinger Bands. The position within the bands is calculated using an adaptation of the formula for Stochastics
16. %b has many uses; among the more important are identification of divergences, pattern recognition and the coding of trading systems using Bollinger Bands.
17. Indicators can be normalized with %b, eliminating fixed thresholds in the process. To do this plot 50-period or longer Bollinger Bands on an indicator and then calculate %b of the indicator.
18. BandWidth tells us how wide the Bollinger Bands are. The raw width is normalized using the middle band. Using the default parameters BandWidth is four times the coefficient of variation.
19. BandWidth has many uses. Its most popular use is to indentify "The Squeeze", but is also useful in identifying trend changes...
20. Bollinger Bands can be used on most financial time series, including equities, indices, foreign exchange, commodities, futures, options and bonds.
21. Bollinger Bands can be used on bars of any length, 5 minutes, one hour, daily, weekly, etc. The key is that the bars must contain enough activity to give a robust picture of the price-formation mechanism at work.
22. Bollinger Bands do not provide continuous advice; rather they help indentify setups where the odds may be in your favor.
1. Bollinger Bands provide a relative definition of high and low. By definition price is high at the upper band and low at the lower band.
2. That relative definition can be used to compare price action and indicator action to arrive at rigorous buy and sell decisions.
3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc.
4. If more than one indicator is used the indicators should not be directly related to one another. For example, a momentum indicator might complement a volume indicator successfully, but two momentum indicators aren't better than one.
5. Bollinger Bands can be used in pattern recognition to define/clarify pure price patterns such as "M" tops and "W" bottoms, momentum shifts, etc.
6. Tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.
7. In trending markets price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.
8. Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.)
9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the width of the bands are just that, defaults. The actual parameters needed for any given market/task may be different.
10. The average deployed as the middle Bollinger Band should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.
11. For consistent price containment: If the average is lengthened the number of standard deviations needs to be increased; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced; from 2 at 20 periods, to 1.9 at 10 periods.
12. Traditional Bollinger Bands are based upon a simple moving average. This is because a simple average is used in the standard deviation calculation and we wish to be logically consistent.
13. Exponential Bollinger Bands eliminate sudden changes in the width of the bands caused by large price changes exiting the back of the calculation window. Exponential averages must be used for BOTH the middle band and in the calculation of standard deviation.
14. Make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The distribution of security prices is non-normal and the typical sample size in most deployments of Bollinger Bands is too small for statistical significance. (In practice we typically find 90%, not 95%, of the data inside Bollinger Bands with the default parameters)
15. %b tells us where we are in relation to the Bollinger Bands. The position within the bands is calculated using an adaptation of the formula for Stochastics
16. %b has many uses; among the more important are identification of divergences, pattern recognition and the coding of trading systems using Bollinger Bands.
17. Indicators can be normalized with %b, eliminating fixed thresholds in the process. To do this plot 50-period or longer Bollinger Bands on an indicator and then calculate %b of the indicator.
18. BandWidth tells us how wide the Bollinger Bands are. The raw width is normalized using the middle band. Using the default parameters BandWidth is four times the coefficient of variation.
19. BandWidth has many uses. Its most popular use is to indentify "The Squeeze", but is also useful in identifying trend changes...
20. Bollinger Bands can be used on most financial time series, including equities, indices, foreign exchange, commodities, futures, options and bonds.
21. Bollinger Bands can be used on bars of any length, 5 minutes, one hour, daily, weekly, etc. The key is that the bars must contain enough activity to give a robust picture of the price-formation mechanism at work.
22. Bollinger Bands do not provide continuous advice; rather they help indentify setups where the odds may be in your favor.
