What Is Bollinger Bands?(Definition, Meaning)
Developed by John A. Bollinger, Bollinger Bands is very important technical indicator used to gauge volatility of any stock. In technical analysis Bollinger bands has a special role to play, it informs traders and investor about the overbought and oversold levels.
If the price is near the upper Bollinger Band, it’s considered “overpriced” whereas if the is price near the lower Bollinger Band, it’s considered “discounted”.
As a trader one may sell when the price reaches the top of the band on the other hand, if the prices reached to the lower band one can look for buying.
Having said that, do not consider only above mentioned things while executing your trades. One should have a deeper understanding of the bollinger bands (BB) before using it, otherwise you might use it wrongly and bear losses.
Bollinger Bands can be used on most financial instruments like equities, indices, commodities, futures, options, currencies, bonds etc.
BB are lines plotted in and around the price structure on chart of any security. It primarily consist of a simple moving average (also known as the middle band), an upper band, and a lower band. This bands helps in identifying, whether prices are high or low on a relative basis.
This curves when gets plotted on a chart helps in taking buy or sell signals. Whenever the price touches the upper band a sell can be triggered. Conversely, when price touches the lower band a fresh buying position can be started.
After reading till now, you might be thinking, OK that’s great so i can just go long(buy) when the price reaches the lower band and when the prices reaches upper just need to start selling.
A big NO, if it was so easy to buy low and sell high, than everyone or anyone would have just followed and have become super rich. Having said that, there are ways or strategies one can adopt to be at better rate of success than with none.
Before we dig deeper inside bollinger bands let us know a little on calculation.
What Is Bollinger Bands Formula?
The Bollinger Band calculations are quite easy. BB are calculated by placing this 3 bands together on chart given below:
- Middle line usually a 20 day simple moving average of the closing prices.
- Upper band –: 20-day SMA – (20-day standard deviation of price x 2) this is plotted +2 standard deviation above the middle line
- A lower band –: (20-day standard deviation of price x 2) + 20-day SMA) this is plotted -2 standard deviation below the middle line
What is standard deviation?
SD in general measures how far you’re away from the average(in this case 20 days SMA). Standard deviation (SD) is same as volatility. For example, if the standard deviation of a stock is 5%, it is equal to saying the volatility of the stock is 5%.
Standard deviation is a mathematical measurement of average variance used in statistics, economics, accounting and finance. Standard deviation calculation also uses a simple moving average formula.
Do not get worried as you will not be calculating this values by your own. On your trading software it is easily done just by few clicks. If you want to learn more about SD you can check this lesson.
Also, if you are not aware about Moving Averages please read it here, it is much more important than knowing SD calculation.
Let us see how BB appears when plotted on chart with above 3 line together:
As, you can see in the above chart, the upper band is +2 SD, keep on sticking to the upper level of the stock price, whereas the lower band is moving near at the bottom of the price. The middle SMA(20days) line shows the stock average price while trading .
The plan is to short the stock when the price touches the upper band with an expectation that it will revert to average. Likewise one can go long when the price touches the lower band with an expectation it will revert to the average.
Hold your horses as you can see Bollinger bands do created the false signals above, starting from left the stock went up, if you have shorted the result would be a profit, but the moment it reached the lower band you might have started accumulating it, results would be devastating.
The price went lower and lower. That is why we need to understand a little more and always use any indicators in combination with other tools and resources.
Tip: In a more volatile market, Bollinger bands widen, whereas the bands narrow in less volatile market.
Best Bollinger Bands Settings:
Bollinger bands setting for intraday traders, specially for a beginner it is advisable to use the default 20 day SMA and 2 SD setting, With time you can do various experiments and can try different other BB settings. You have to choose this settings before plotting the BB on chart, you can also edit them if it does not giving you enough signals.
Few other BB settings you can try:
|50(SMA) Periods with 2.5 SD||10 (SMA)Periods with 1.5 SD|
|Upper band = 50 Day SMA + 2.5 (SD)||Upper Band = 10 Day SMA + 1.5 (SD)|
|Middle Band = 50 Day SMA||Middle Band = 10 Day SMA|
|Lower Band = 50 Day SMA – 2.5 (SD)||Lower Band = 10 Day SMA – 1.5 (SD)|
5 Best Bollinger Bands Trading Strategy
There are various ways in which you can use the Bollinger bands indicator apart from plain BB that we have learned above.
The best strategies are those which have multiple indicators involved because the chances of your failure would be much less as compared to using only one.
For example instead of looking to sell at the top of the band and buy at the bottom, one should also look closely how the candlestick patterns are forming at those levels.
Another thing to look is the primary trend of the stock, is the stock in uptrend or lower, you can easily do that by drawing and trend line on the chart or just looking 1 complete month candles at one shot.
If you do not know how to draw trend line or want a different method, than just plot a 50,100 or 200 day(user lesser days for intraday 50 is great but for short term or positional traders one can use above 50 day SMA) Moving average, if the stock is below the MA, it is in downtrend if it is above its a sign of uptrend.
Also keep in mind to check various support and resistance zones, this is very important as they can help you to make a entry and exit.
I would suggest you to have at least 3 to 4 technical tools and indicators in your arsenal, so that you can make different strategies and can experiment with them. Having said that let us move and see some best strategies based on BB.
What is Bollinger Bands Squeeze Strategy?
Volatility in stock market keeps on changing but as we know BB are best to gauge the volatility in stocks, so it is advisable to use this strategy.
The markets keep on moving from a period of high volatility to low and low to high volatility. Bollinger Bands can help in such situations because it contracts(squeeze) when volatility is low and expands(widen) when volatility is high.
Look at the chart below to get what i mean to say:
Above is AXIS bank(1 hour) chart, it is clearly visible how Bollinger Bands squeezed due to low volatility, this will lead to a possible breakout, which will be in the same direction, where the primary trend.
As i have also plotted a 50 day MA, which is above the stock current trading price suggesting about the bearishness of the stock.
The stock is so bearish that even it can’t able to sustain above its middle band which is a 20 day MA part of bb. when the contraction happens or breakout happens, the BB will get widen, this signals you to make a short trade in case of bearish trend or long(buy) in case of bullish uptrend.
Let me show you another chart with the same pattern:
Bollinger Bands With RSI Divergence:
Besides the RSI indicator scores of 30 and 70 – which may advise you potentially oversold and overbought market conditions, traders also make use of the RSI to try and predict trend reversals. RSI also tell you the strength or weakness behind the move.
Such an approach is based on the bullish and bearish divergences.
RSI bearish divergence forms when the price forms a higher high, and at the same time the RSI decreases, and forms a lower high. You will usually see RSI divergence forming at the top of the bullish market, and this is known as a reversal pattern.
On the other hand, the RSI bullish divergence will form when the price forms a lower low, and the RSI forms a higher low. This is an advance warning sign that the trend direction might change from a downtrend to an uptrend.
Basically, a divergence exists when your indicator does not “agree” with price action on the chart. One can combine this with bollinger bands indicator to look for selling at the top and buying at the bottom of the trend.
take a look at the below chart:
In above (1hour)chart, look at the top of the trend as well as at the bottom on Relative strength index RSI, RSI is showing there is no upward momentum in the price as the RSI, is make higher lows, instead if going up, this is called bearish divergence.
This indicate weakness in the underlying move, one could have placed a short position.
similarly, the stock was beaten down within couple of hours, however if you see the chart on right, RSI is gaining the strength by making higher high, even when the stock is down, which reflects the trend reversal is about to happen, also known as bullish divergence. One could have made a fresh buying position here.
So, instead of simply buying at the bottom of the BB, and selling at the top, one could use it with another indicator such RSI, to place better trades with more accurate results in favor.
Bollinger Bands With Support, Resistance And Candlestick Patterns:
Another great combination strategy is using support and resistance zones with, the upper and lower Bollinger bands. Also keep in mind to check the candlestick patterns at the top and bottom of the band to be extra careful. Below chart(1 day) is best suited for positional traders.
If you can hold the position for 2 to 5 days , you can churn great profit from such strategies.
Look at the chart below:
Starting from left the stock fall to a level touching the lower band of the BB, the candlestick pattern at that point is bullish engulfing, as the red candle is fully engulfed in front of the big green candle, showing the trend will be reversed with the entry of bulls. One could have easily made huge profit within a week of holding.
However at the top of the BB, where there is resistance zone, another pattern appears bearish engulfing, the stock did fall, but did not went below the mean of the bollinger bands i.e. the 20 day sma line.
This is best suited for intraday trade setup seeing such candles at the top. The stock started falling again once it breached the median 20 day line, with strong bearish marubozu candle(long red candle falling below the black line). One could have short or did STBT (sell today buy tomorrow)trade.
Now, when the stock touched the same level from where it rose, that level has been converted in to support area for the stock, a great chance of trend getting reversed.
Bollinger Bands With MACD Indicator
MACD indicator is indisputably very popular momentum(trend) indicator used in technical analysis in stock market. MACD is a acronym used for Moving Average Convergence Divergence. MACD indicator is a combination of two different exponential moving average.
Out of the two moving averages one is of shorter time period(12 day EMA) and the other longer time period(26 day EMA). It gets calculated by subtracting 26 day EMA from 12 day EMA.
This results in giving a MACD line. After that, a 9 day ema also called as signal line is plotted on the top of the MACD line to generate a trigger for buy and sell signal for any stock or index.
One can buy(go long) the security when the MACD(line) crosses above its signal line(9 day EMA line) and sell (go short) the security when the MACD crosses below the signal line.
Using it with bollinger bands makes it fantastic combination, reason being MACD is momentum indicator, it will tell you beforehand is the trend losing the charm.
It will create a potential buy and sell signal which can help you to decide whether to sell at the top of the band or buy at the bottom of the band.
Let us see in 1(hour) chart of HDFC BANK below:
First let me tell you what’s the idea behind the MACD, you see the central line in mid(with bars showing up and down, do not get confused as those bars are not volume bars it is called histogram), i.e. also known as zero line,
whenever the MACD line (black in above case), goes above the central line, one should look for buying, whereas if it going below the central line one should look for shorting.
But, do you see a orange line, also called as signal line, whenever the macd line(black) goes below(crossover) the signal line(orange in above case), the trend is bearish conversely, if the macd line is going above the signal line it is indicating bullish trend.
I hope you have understood the above concept now, whether you should sell at the top of the band can easily be identified with the help of macd indicator.
Do you see in the above graph starting from left , when the price touched the top band with red candlestick, which itself means the trend is not going to sustain, however one can wait for the crossover of the macd to short, also see the median band(21 day sma), the prices are not sustaining to this levels.
The moment MACD line(black) crossed the orange line signal line, one could have placed a short trade or else to be on the safer side one could wait till the black macd line is going below the central line.
Similarly for buying, you can see at the left when the macd line is above the central and signal line and stock price is at the bottom of the band, one could initiate a buy trade.
Another great thing happens on the chart is at right side when you the stock hit the upper band, but the macd line is below the central line which is strong indication that there is no momentum in the price of the stock and sooner or later bears will take over this.
Bollinger Bands Trading Strategy Points To Remember:
- Closer the prices move to the upper band, more overbought the market
- Closer the prices move to the lower band, more oversold the market
- Buying when stock prices cross below the lower Bollinger Band
- Selling when stock prices cross above the bollinger band
- It is useful in trending as well as non-trending market
- The upper and lower bands act as a trigger to open a trade
- In an uptrend, you can long near the lower Bollinger Band
- In a downtrend, you can short near the upper Bollinger Band
- When the Bollinger Bands is in a squeeze, it signals the market is “ready” to breakout
- Breakout above or below the bands is a crucial event
- The breakout is not a trading signal. However a new trend towards up or down indicates a strong momentum
- Wider the bands greater is the volatility
- Narrow bands reflects low volatility hence sideways movements
- Bollinger Bands are not meant to be used as a stand-alone tool
- Analyst should combine Bollinger Bands with basic trend analysis and other indicators for confirmation. Like Candlestick patterns, Volume, SR, MACD,MA, RSI etc.
I hope you have enjoyed above guide on Bollinger Bands and the best Bollinger bands strategies, but here is thing BB indicator is just a tool, It does has flaws, and sometime may not produce the reliable signals.
It can help you stay on the right side of trend and spot potential reversals, though. My opinion would be to try any one strategy at a time and better to try through paper trading first instead in live market to check whether its working or not.
I hope and wish you all the best for your trading and investing journey ‘May the force be with you’.?✌
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