What are Bollinger bands?
Bollinger bands are one of the most used trading indicators by market operators to compare the changes in the price of any asset and the relative value of its price over a period of time.This indicator was created in the 1980s by John Bollinger and consists of three bands that are drawn superimposed on the price evolution chart.
- The central band is a moving average. Normally, a simple moving average calculated with 20 periods is used, which represents the evolution of the average of the last 20 periods over time.
- The upper band is calculated by adding to the value of the simple moving average 2 times the standard deviation of the moving average.
- The lower band is calculated by subtracting from the simple moving average 2 times the standard deviation of the moving average.
The standard deviation is a statistical parameter that provides a good indication of changes in market value, since it takes into account the variation of the values that comprise the average.
For example: a period of 9 and another of 11 give 10 as an average ((9 + 11) / 2 = 10), and that average will have a standard deviation of 1. On the other hand, the resulting standard deviation of a average between 1 and 19: the mean, again, will be equal to 10 ((1 + 19) / 2 = 10), but the standard deviation will be 9.
Therefore, the use of this parameter to calculate the bands ensures that they will respond quickly to price variations, reflecting periods of high and low probability of change. Likewise, the band between the upper and lower bands contains, statistically, almost 90% of the possible price variations. This means that any price movement outside the bands is highly unlikely and thus of particular importance.
For these reasons Bollinger bands are used to:
- Identify periods of high or low volatility.
- Identify trend changes in the price.
- Identify strength or weakness in the price trend.
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Volatility indicator
The value of the standard deviation of a series increases as the value of the product increases and decreases as the value of the product decreases. Therefore, since the width of the band is determined by the value of the deviation (it is equal to four times the standard deviation), the bands automatically widen when the value of the price increases and narrow when it decreases, bringing the prices closer together. upper and lower bands.When this narrowing in the bands occurs in a drastic and sudden way, it can be interpreted as a warning of an imminent and significant movement in prices. The direction in which the prices will move will be determined by the position of the price in relation to the moving average within the narrowing of the bands.
https://preview.redd.it/80h6fuivd4x91.png?width=763&format=png&auto=webp&s=0a491aa03d4cf95d9996ac98086062cf8c95251b
In the example above, which corresponds to the daily price of the NYSE Index, it can be seen how the sudden narrowing of the bands registered in early December 2016, in which the price moved above the moving average throughout of the entire duration of the tightening, anticipated the strong upward movement with which the index ended the year 2016.
Therefore, if a sustained narrowing of the upper and lower bands is noted, a sudden price movement can be assumed. Its direction will be expressed by the side the price is on with respect to the moving average band, along that narrowing:
- If the price is between the moving average and the upper band, the expected sudden movement will be in the form of an increase.
- If the price is between the moving average and the lower band, the expected sudden movement will be in the form of a downside.
Identify price trend changes
Bollinger bands are also used in technical analysis as a complement to the study of trend reversal figures:- W or double bottom, figure that indicates the change from bearish to bullish trend.
- M or double top, a figure that indicates the change from bullish to bearish trend.
Formation of a W figure or double bottom.
In technical analysis, a double bottom or W is formed in a downtrend and is a figure that usually anticipates a change in trend. Bollinger bands are a very helpful instrument to confirm the formation of said figure, as explained below:The first signal to watch out for is a price closing (first floor) below or close to the lower band. This is followed by a bullish reaction that drives the price towards the central band, ie the moving average. The next sign is a further drop and the formation of a second bottom, which should be above the lower band, indicating less weakness than the first bottom.
Finally, the signal that confirms the change in trend figure is a strong upward movement that leads the price to even exceed the upper band. An example of the formation of this reversal W figure is shown in the following chart, which corresponds to the daily price of Apple:bollinger bands chart example
https://preview.redd.it/3i7ntps0e4x91.png?width=737&format=png&auto=webp&s=41fd21156c9bc6a87401a4c4896d245c8eb989a4
Formation of an M figure or double top.
In , a double top or M forms in an uptrend and is a figure that anticipates a change in trend. As in the previous case, although in an inverse way, the Bollinger bands are a very helpful instrument to confirm the formation of said figure:The first signal to watch out for, in this case, is a price closing (first top) below or close to the upper band. As can be seen, from the beginning, the M figure or double top follows steps very similar to those of the W or double bottom, although with the opposite direction. What follows is a bearish reaction that drives the price towards the central band.
The next signal is the formation of a second top, which should be below the upper band, indicating less strength than the first top. Lastly, the signal that finally confirms the change in trend figure is a strong downward movement that leads the price to break the lower band. The following chart, which corresponds to the daily price of Exxon, shows an example of the formation of this trend reversal M figure:
https://preview.redd.it/xonzson3e4x91.png?width=703&format=png&auto=webp&s=0b5cfca09cd422943d2c9f34904eefc60373bcf0
Identify strength or weakness in the price trend
From a technical point of view, by the very definition of the bands, prices are considered relatively high when they touch the upper band and relatively low when they touch the lower band. However, movements above or below the band are not trend signals by themselves. Rather they should be viewed as indicators of the strength of that trend.In the case of an uptrend, such as that depicted in the Apple daily stock chart below, price closes above the upper band are indicators of the strength of the move. It must be taken into account that the upper band is formed by adding 2 times the standard deviation to the moving average, which gives an idea of the important upward momentum that the price must have in order to overcome said upper band.
The same reasoning, but in reverse, can be applied in the case of a downtrend, where price weakness would be indicated by successive closes below the lower band.
In addition to comparing and indicators in parallel to better visualize price trends.
https://preview.redd.it/3fiza5h5e4x91.png?width=739&format=png&auto=webp&s=38080970b98a3e3894ffe854c3cd1505e48e7125
The Bollinger Bands Squeeze
Another characteristic of Bollinger bands to keep in mind is “the squeeze”, also known in English as the squeeze , which happens when the bands narrow enough upwards that they seem to come together or coincide.Hence the name, when the bands "tighten" or converge the price, and this event helps to indicate a price with low price variation and a consolidated market environment, so it could be considered as an opportunity to make trading .
It is common for breakout traders, a trading strategy based on breakouts of pre-set price levels, to look for such periods and wait for another trading opportunity to appear from this consolidation to take advantage of this new trend. .
Regardless of what type of operator you are, the following points must be taken into account:
- The moment the high variation in price returns to the market, the upper band will go up and the lower band will go down.
- If the price converges with the upper band, this indicates a bullish breakout.
- If the price converges with the lower band, this indicates a bearish breakout.
- The longer the squeeze, the stronger the break.
- If the Bollinger bands widen noticeably, this may indicate that the price is breaking out of a consolidation into a new trend.
How to set Bollinger bands on your platform?
- Period or size: because the simple moving average is calculated with 20 periods, usually the default setting is 20. However, if you consider it convenient to change it, you can do so.
- Deviations: The standard deviation multiplier for both the upper and lower bands is preset to 2. But you can also change the multiplier if you wish.
- Price Entries: The widely used price on platforms is the “Close” price. However, there are also the options of “Open”, “Maximum”, “Minimum” and “Median” to define the price calculations.
Conclusion
Bollinger bands are widely used indicators in technical analysis in trading. These bands are very useful for traders to compare the price changes of a specific asset over a period of time (its last 20 periods over time.)It is important to remember that markets experience both periods of low price variation and high variation, and Bollinger bands help identify these periods. Likewise, the bands serve to identify the strength or weakness of the price trend, or the possible changes in these price trends, so it is essential to understand them and know how to read their charts.
Finally, although bands are a very useful indicator, they should not be used in isolation or as the only trading instrument , but rather as a complement to other important technical analysis indicators.
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