What are Bollinger Bands?
Bollinger Bands are a tool that stock traders use. They help show how stock prices go up and down. The bands use math to make three lines on a chart.
The middle line is a moving average. This is the normal price over the last 21 days, for example. The top and bottom lines go above and below the middle line. They capture most of the price changes in that time.
How the Bands Work
The top band is two standard deviations above the middle line. The bottom band is two standard deviations below it. Standard deviation measures how spread out the prices are from the average.
When prices get more volatile, they move more. This makes the bands get wider apart. When prices are stable, the bands get closer together.
What Bollinger Bands Tell Traders
Bollinger Bands give useful signals to traders:
Volatility
Wide bands mean high volatility. The stock price is swinging a lot. Narrow bands mean low volatility. The price is more stable.
Relative Price Level
Prices near the top band are high compared to recent prices. This could mean the stock is overbought. Prices near the bottom band are low compared to recent prices. This could mean the stock is oversold.
Trend Strength
Prices trending between the bands show a strong trend. The trend is up if prices hug the top band. It is down if they hug the bottom band. A weakening trend will move toward the middle line.
How to Use Bollinger Bands
Here are some common ways traders use Bollinger Bands:
Breakouts
Watch for prices to break out of the bands. This could signal the start of a new move up or down. A valid breakout should close outside the band.
Reversals
If prices hit the top band and turn down, it could signal a pullback. If they hit the bottom band and turn up, it could signal a bounce.
Trend Confirmation
In an uptrend, look for prices to stay above the middle line. Pullbacks should find support at the middle line. In a downtrend, prices should stay below the middle line. Rallies should hit resistance at the middle line.
Squeezes
When the bands get very narrow, it is called a squeeze. This means the price is very stable. But it also often comes before a big move. Watch which way the price moves when it breaks out of the squeeze.
Bollinger Band Strategies
Traders combine Bollinger Bands with other tools in their strategies:
Double Bottom
Look for the price to tag the bottom band twice with a modest rise in between. This W-shaped pattern could lead to an upside breakout.
Riding the Bands
In a strong trend, buy when the price touches the middle band. Trail your stop under the bottom band. In a downtrend, short when the price hits the middle band. Trail your stop above the top band.
Reversals
Buy when the price breaks above the top band after tagging the bottom band. Sell when it breaks below the bottom band after tagging the top band.
Limitations of Bollinger Bands
Bollinger Bands are a helpful tool but have some limits:
- False signals can happen, especially in choppy markets.
- Bollinger Bands are reactive, not predictive. They tell you what has happened but not what will happen.
- You should confirm signals with other tools like momentum indicators and chart patterns.
- Bollinger Bands work best in markets that trend. They can give confusing signals in range-bound markets.
