Bollinger bands are to trading what Shakespeare is to literature, very important and really hard to avoid if you are trying to make a mark in the world of trading. Bollinger band is a technical indicator used to analyse the market in a better manner and help us in making better assumptions on the price of an asset ie if it is overbought or oversold.
In this article, we will be covering:
- How to graph Bollinger Bands
- Bollinger Bandwidth
- Bollinger Band based Trading Strategies
- 20-day moving average
- Upper Bollinger band
- Lower Bollinger band
Let’s talk about them in detail below.
1. 20-day moving average
A moving average is simply the average of a series of numbers. Let’s take the example of Tesla Motors (TSLA). For the month of February, the closing prices were:
If we had to calculate a 5 day moving average for the close price in the above table, we will start by finding the average of the first five values, ie (312 + 313 + 321 + 317 + 308)/5 = 1571/5 = 314.2.
For the next column, it will be the following values, (313 + 321 + 317 + 308 + 306)/5 = 1565 / 5 = 313
Plugging in the other values, the table would now look like this,
If we were to create a graph of the following, it would look like the following,
In a similar manner, instead of a 5-day moving average, for Bollinger bands, we use the 20-day moving average. A sample is shown below. (Data is taken for Tesla from 13 October 2018 to 16 October 2018)
2. Upper Bollinger band
The upper Bollinger band is constructed by moving 2 standard deviations above the 20-day moving average.
Thus for the data above, the upper Bollinger band, when added to the graph, would look like this.
3. Lower Bollinger Band
Similar to the upper Bollinger band, we construct the lower Bollinger band two standard deviations below the 20-day simple moving average (SMA).
The reason why the upper and lower Bollinger bands are two standard deviations away from the moving average is that this makes an envelope around the closing price and contains the majority of the price action. Statistically, two standard deviation includes 95% of price movement. Thus, any time the closing price goes below or above the Bollinger bands, there are high chances for breakout or price reversion, and hence it can be used a signal.
The beauty of Bollinger Bands is that it can be used in any type of market, from stocks to derivatives, as well as forex.
In addition to the Bollinger Bands, John Bollinger has said that we should look in the bandwidth of the band too, to help us in our analysis. It is very simple to calculate the bandwidth, which is as follows:
[(Upper Band - Lower Band)/SMA] * 100
Bollinger Bandwidth is effectively used to identify the Bollinger Band squeeze.
We now move on to the main event, trying to figure out how to use Bollinger Bands to create a trading strategy.
Bollinger Bands based Trading Strategies
We talked about how the Bollinger Bands contain most of the price action in the bands. This means that at any time if the price moves above or below the Bollinger bands, it can be used as a signal.
This is the logic for the reversal trading strategy. We know that fear and greed drive the market. Thus, we can say that if the price goes above the upper Bollinger band, it could be a sign that the trend might reverse. A similar case is when the price goes below the lower Bollinger band.
You can see in the stock chart above, on 27 September, the price breached the lower Bollinger band and then subsequently went bullish for the next few days.
One must understand that the reversal of the price trend can happen due to a variety of factors, not least because of the bands themselves.
For example, while in the graph of the Tesla Bollinger bands, you will see that the price took a nosedive, which was due to the news that SEC had sued Elon Musk over false news.
Bollinger Band Squeeze
Bollinger bands help us to understand the volatility of an asset. When the market is strongly bullish (or bearish), due to their inherent properties, the Bollinger Band envelope will widen dramatically. In low volatility periods, or when the price of the asset is pretty much stagnant, the Bollinger Band envelop shrinks, effectively squeezing against the SMA.
Bollinger Band strategy is used to identify a period where the bands have squeezed together indicating that there is a breakout which can happen.
Unlike the strategy discussed above, where you know the direction of the trend, it can be hard to predict which direction the price would go after a period of low volatility.
For example, in this chart, you can see the Bollinger band squeeze in the middle, from 21 November to 12 December before breaking out.
While the double bottoms strategy is not exactly unique to the Bollinger bands, it can be used efficiently with it. In a double bottom setup, as the name suggests, we are looking for a W shaped formation where the price closes below the lower band once before increasing the next period for a short while, only to close below the lower Bollinger band again.
It is at this precise moment where most traders are confident that the price will increase and sustain itself.
Usually, traders hone in when the price breaches the lower band and rebounds for a short while before diving again. If the second low is above the lower band, it is generally assumed that it is a double bottom and there is a strong chance that it will be an uptrend.
For example, we can see that on 7 September, the price breached the lower Bollinger Band and then rebounded. The price reduced again but did not breach the lower Bollinger band and thus, this can qualify as a Double bottom setup.
If we go further, we can see the same pattern on 5th October onwards.
Similar to the double bottom which is focused on the lower Bollinger band, the double top occurs at the upper Bollinger Band. The double top formation is a rare occurrence compared to the double bottoms which were seen earlier.
In the double top (or M top) we tend to look at the price which breaches the upper Bollinger band before decreasing for a while and then increasing again. The traders will check if the second rise closes below the upper Bollinger band and only then will they short the asset.
For example, the price breached the upper Bollinger band on 7th August and then reduced below the upper Bollinger band again. It rose again on 10th August but did not breach the upper Bollinger band. Thus, this qualifies as a Double top setup.
Trading in the bands
One strategy effective for the relatively low-risk individual who is content with low but safe returns on their investment is to trade by keeping the SMA as the signal to enter or exit the trade. Since the SMA is essentially an average and the price keeps swinging from one side of the SMA to the other, you are bound to end up with a profit. This strategy can also be used in times of very low volatility.
In the chart, you can see that on 6 February when the price reaches the SMA, it changes direction and reaches the lower Bollinger Band before reversing direction once again.
A variation on the earlier strategy is that instead of exiting when the price touches the SMA, we enter the trade when it is inside the band and trending, and exit when it touches the other band. For example, if the closing price had touched the lower Bollinger Band before increasing again, and if we are confident that it will sustain the price increase, we buy the stock and exit when it touches the upper Bollinger band.
In the chart, you can see that price changing the direction once it touches the upper Bollinger Band on 9 May and similarly changing its direction once again when it touches the lower Bollinger Band on 22 May.
The limitation of Bollinger Bands is that they are computed using a 20-day Moving Average, meaning that they weigh all data points as the same. Thus, a recent event is not given more weightage and can impair the indicator’s ability to correctly observe a trend.
It is generally accepted that we shouldn’t use the Bollinger Bands as the sole indicator to place a trade as it will not be as profitable due to the simple fact that the market will not reward an individual for performing the obvious. A good idea is to pair it with other indicators such as MACD or RSI to make a better trade decision.
In summary, Bollinger Bands are a good way to understand the price action of an asset and helps us in forming better decisions on when to enter a trade. You can use a combination of different indicators to create your own strategy. The starter pack of Algorithmic Trading Strategies will help you create quantitative trading strategies using technical indicators which can adapt to live market conditions.
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.