Bollinger Bands are a popular technical analysis tool that used by investors, traders to analyze price volatility and potential price reversals in stock market. They consist of three lines plotted on a price chart are- i) the middle band, ii) the upper band, and iii) the lower band.
The middle band is typically a simple moving average (SMA) of the price over a specified length of time while the upper and lower bands are calculated by adding and subtracting a specified number of standard deviations taken from the middle band.
The formula to calculate Bollinger Bands is as follows:
Middle Band: Simple Moving Average (SMA) Middle Band = n-period SMA
Upper Band: Upper Band = Middle Band + (k * n-period Standard Deviation)
Lower Band: Lower Band = Middle Band - (k * n-period Standard Deviation)
Here, "n" is representing the number of periods that used for the calculation (e.g., 20-day, 50-day) and "k" is representing the number of standard deviations to be added or subtracted (e.g., 2, 2.5).
Primary uses of the Bollinger Bands theory is to identify periods of high or low volatility in the price of an asset. When the price is relatively stable then the bands contract, while during volatile periods, the bands expand. Analysts look for potential trading opportunities based on these observations.
Let's consider an example using a 20-day Bollinger Band with 2 standard deviations:
- Price Breakout: It suggests a potential bullish signal indicating that the price might continue to rise when the price breaks above the upper band. Analysts, traders or investors may consider buying the security at this point. Conversely, if the price breaks below the lower band then it indicates a potential bearish signal and suggesting that, the price may continue to decline. Here analysts may consider selling or shorting the security.
- Squeeze: Bollinger Bands contraction, known as a 'squeeze', it occurs when the volatility decreases significantly. It often precedes a period of high volatility. Traders watch for this squeeze and anticipate a potential price breakout in either direction. When the bands start to expand again, it may indicate the beginning of a new trend and traders can take positions accordingly.
- Support and Resistance: Bollinger Bands can also act as support and resistance levels. During an uptrend, the price tends to bounce off the lower band, which acts as support. Similarly, during a downtrend, the price tends to bounce off the upper band, which acts as resistance. Analysts, traders or investors can use these levels to identify potential entry or exit points.
- Volatility Expansion: When the bands expand significantly, it suggests a period of high volatility. Traders can use this information to adjust their trading strategies such as widening stop-loss orders or reducing position sizes to manage risk.
Finally, it is important to note that, Bollinger Bands are not foolproof indicators and they should be used in conjunction with other technical analysis tools and indicators to make informed trading decisions.
