Bollinger Bands: Definition
In the financial markets, Bollinger Bands recognized as a technical analysis tool that was created by John Bollinger in the early 1980s. Initially, it was called trading bands but later on the concept evolved and called it Bollinger Bands. It is a type of statistical chart that is used to characterize the volatility and prices over time of a financial instrument or commodity. That’s why many financial traders use Bollinger Bands formula as a technical analysis tool for trading strategy and to make informed trading decisions.
In a Bollinger Bands chart, three lines are drawn with one below, one above and one in the middle to form an envelope. The middle band is a simple moving average however the upper and lower bands are typically 2 standard deviations.
The Bollinger Bands provide a relative definition of high and low. Since the standard deviation is a measure of volatility, it is shown on the basis of standard deviation for a particular financial asset or commodity, which is denoted by upper and lower band/ line. During the high volatility periods the bands widen; during less volatile periods, the band’s contract or narrow.
How to Calculate Bollinger Bands?
Bollinger Bands are not much different from moving average envelopes expect the drawing calculations are entirely different. Bollinger Bands indicate the levels of different highs and lows that a financial security price has reached in a specific period of time. The upper line indicates high and lower line indicates lows. Overall, the upper and lower lines/ bands form an ‘envelope’ that helps in recognizing the pattern at a specific time.
In calculating the Bollinger Bands, the following variables are required:
- Time Period (N)
- Standard Deviation Value (s)
- Three Bollinger Bands/ Lines
The Bollinger Bands consists:
A Moving Average (MA) for ‘N’ Period, an upper band at K times an N-period standard deviation above the moving average (MA + Kσ), and a lower band at K times an N-period standard deviation below the moving average (MA – Kσ).
Typically the values of N and K are 20 and 2 respectively. Generally, the traders use a 20-day simple moving average with a standard deviation of 2. However, there is not mandatory to use the simple moving average only. Sometimes, the traders use the exponential moving average too.
For better understanding, let’s draw Bollinger Bands for Nifty50 when data is set for daily close value, MA is 20-Day SMA, and the standard deviation value is 2.
Here the upper blue line/ band, showing standard deviation above moving average, which is a 20-Day SMA + (20-Day SD of price x 2)
The red line in the middle band is showing 20-day simple MA.
The lower blue line/ band, showing standard deviation below moving average, which is the 20-day SMA + (20-Day SD of price x 2)
If we look at the image, we can see that the band was widest when Nifty50 was volatile when Nifty50 was volatile during February and March, the band narrowed when Nifty50 was consolidating during May to August.
Bollinger Bands: Interpretation
- When the bands contract, the volatility drops and the possibility of sharp changes in price increases.
- When the price range crosses the band’s range, there is a possibility of a strong continuation of the current trend.
- The new highs and lows outside the bands followed by highs and lows inside the bands indicate the trend reversal.
- Most importantly, when the price moves to the upper band, it signals an overbought market, and when the prices are close to the lower band, that signals an oversold market.
Generally, stock traders tend to buy when the price is near the lower Bollinger Bands and exit when the price line touches the middle line.
Technically, the prices are high when above the upper band and relatively low when below the lower band however relatively high is not regarded as a bearish signal, and vice-versa. Bollinger bands are a very important technical analysis tool but would not recommend using as a stand-alone tool.
Hope, this article helped you in a way you expected it to be. If you have any query or would like to ask something then doesn’t forget to mention in the comment section below.