Bollinger Bands
Bollinger Bands are a indicator created by John Bollinger in the 1980s. The indicator consists of three lines: a middle band (a ) and two outer bands that sit above and below it.
The bands expand when markets become volatile and contract during calmer periods. This dynamic behavior helps traders identify potential price extremes and anticipate significant moves.
Apple (AAPL) Stock Price and customizable Bollinger Bands (BB)
How Bollinger Bands Work
Bollinger Bands provide a relative definition of high and low prices based on recent . Unlike fixed price levels, the bands adjust automatically as market conditions change.
The middle band serves as a baseline, representing the average price over a specific period (typically 20 days). The outer bands are positioned at a distance from this middle line, capturing most normal price movement.
Think of it this way: If the middle band is like the average speed on a highway, the outer bands represent the typical range of speeds you'll see. When traffic gets chaotic (high volatility), that range widens. During smooth traffic (low volatility), everyone drives at similar speeds.
Calculation
The middle band is a simple moving average (SMA), typically using 20 periods:
The upper and lower bands are calculated by adding and subtracting a multiple (typically 2) of the standard deviation:
Where:
With the default setting of 2 standard deviations, approximately 95% of price action falls within the bands under normal conditions.
Example:
Let's calculate Bollinger Bands for a stock with the following 20-day closing prices, where the most recent price is $52.00:
First, calculate the 20-period Simple Moving Average:
Next, calculate the standard deviation. For each price, find the squared difference from the mean, sum them, divide by 20, and take the square root:
Now calculate the bands using the 2 standard deviation multiplier:
With the current price at $52.00, it sits slightly above the middle band ($51.00) and well within the outer bands ($47.16 to $54.84), indicating normal price behavior without extreme conditions.
Common Trading Applications
Identifying Overbought and Oversold Conditions
When price approaches the upper band, the asset may be . When price nears the lower band, it may be .
However, this interpretation has important limitations. In strong , price can "walk the band" for extended periods without reversing. An uptrending stock might repeatedly touch the upper band as it climbs higher. These signals work more reliably in ranging markets where price oscillates between the bands.
The Bollinger Band Squeeze
The "squeeze" occurs when the bands contract to their narrowest point, indicating unusually low volatility. This pattern often precedes a significant price move as markets shift from calm to active.
The squeeze acts as a warning that something is about to happen, but it doesn't predict direction. The could go either way. Traders watch for the squeeze as a signal to prepare for action, then wait for directional confirmation before entering positions.
Bollinger Band Breakouts
When price breaks above the upper band with strong , it can signal the beginning of an . Similarly, a break below the lower band may indicate the start of a .
False breakouts are common, particularly in choppy or ranging markets. Many traders wait for confirmation, such as a close beyond the band followed by continued momentum, before acting on breakout signals.
Adjusting Bollinger Bands Settings
Period (Length)
The default setting is 20 periods, representing the number of data points used for the moving average calculation. This works well for many trading scenarios but isn't universally optimal.
Shorter periods (10-15) make the bands more sensitive to price changes, generating more signals but also more false alarms. Longer periods (30-50) create smoother, less reactive bands that filter out short-term noise but may lag significant moves.
Best For Shorter Periods:
- Day trading and short-term strategies
- Volatile markets with rapid price changes
- Traders who prefer more active trading signals
Best For Longer Periods:
- Swing trading and position trading
- Stable markets with gradual trends
- Traders seeking fewer but more reliable signals
Standard Deviation Multiplier
The default multiplier is 2, placing the bands at 2 standard deviations from the middle. This captures approximately 95% of normal price action.
Some traders use 2.5 or 3 for wider bands that are touched less frequently, making signals potentially more significant when they occur. Others use 1.5 for tighter bands that are touched more often, suitable for range-trading strategies.
Price Source
Most traders use closing prices for calculations, but other options exist. Some traders use typical price (high + low + close) / 3 for a more balanced view, while others experiment with high or low prices depending on their strategy.
Combining with Other Indicators
Bollinger Bands work more effectively when combined with other :
RSI (Relative Strength Index): When price touches the upper band AND exceeds 70, the overbought signal becomes stronger. Similarly, price at the lower band plus RSI below 30 reinforces an oversold reading. This combination reduces false signals by requiring confirmation from multiple sources.
Volume: Breakouts accompanied by unusually high volume are more likely to be genuine and sustainable. Low volume breakouts often fail and reverse quickly. Volume acts as a confirmation tool, indicating whether market participants are truly committed to the move.
MACD: When price walks along one of the bands, helps confirm the trend's strength and potential continuation. between price and MACD while price is at a band can signal an impending reversal.
Key Takeaways
Bollinger Bands consist of three lines: a middle simple moving average and two outer bands positioned at standard deviation distances. The bands expand during volatile periods and contract during calm periods, automatically adjusting to market conditions.
Price touching the outer bands can indicate overbought or oversold conditions, but this signal requires context. In strong trends, price often walks along one band without reversing. These signals work more reliably in ranging markets.
The "squeeze" pattern (narrow bands) often precedes significant price moves but doesn't predict direction. Traders watch for squeezes as warning signals, then wait for breakout confirmation before entering positions.
Bollinger Bands work more effectively when combined with other indicators for confirmation. RSI confirms overbought/oversold conditions, volume validates breakouts, and MACD confirms trend strength.
Default settings (20 periods, 2 standard deviations) suit many situations but can be adjusted. Shorter periods increase sensitivity for active trading, while longer periods reduce noise for position trading.