What Are Bollinger Bands?

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Bollinger Bands are a technical analysis tool developed by John Bollinger in the 1980s. They consist of a simple moving average (typically 20-period) of a security's price and two standard deviation lines placed above and below the moving average. These bands represent the volatility of the price, expanding when volatility is high and contracting when it is low.

The middle band (the moving average) helps identify the general trend of the security's price. The upper band represents the upper volatility range, while the lower band represents the lower volatility range. These bands dynamically adjust according to the changes in price volatility.

Traders and investors use Bollinger Bands to identify potential buy and sell signals, as well as to gauge the strength and direction of a trend. When the price moves towards the upper band, it indicates the security is overbought, suggesting a potential reversal or correction may occur. Conversely, when the price moves towards the lower band, it indicates the security is oversold, potentially signaling a buying opportunity.

Bollinger Bands can also help determine the volatility of a security. When the bands contract, it suggests low volatility, often preceding a period of high volatility and significant price movement. This contraction is referred to as a "squeeze" and traders may anticipate a breakout in price when this occurs.

Aside from price action analysis, Bollinger Bands can be combined with other technical indicators to create trading systems and strategies. They are widely used in different financial markets, including stocks, commodities, and currencies, to identify potential trading opportunities based on price volatility and market conditions.

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How do Bollinger Bands work?

Bollinger Bands are a commonly used technical analysis tool developed by John Bollinger in the 1980s. They are plotted on a price chart and consist of a middle band, an upper band, and a lower band, utilizing a moving average and a measure of volatility.

Here's how Bollinger Bands work:

  1. Middle Band: Bollinger Bands are based on a simple moving average (SMA) of the price. The middle band represents the SMA and is usually set to a 20-day period, but it can be adjusted based on the trader's preference.
  2. Upper Band: The upper band is typically placed two standard deviations above the middle band. The standard deviation is a measure of volatility, representing how much the price fluctuates over time.
  3. Lower Band: The lower band is placed two standard deviations below the middle band, at the same distance as the upper band.
  4. Price Volatility: Bollinger Bands automatically expand and contract based on market volatility. In periods of high volatility, the bands widen, meaning the price is more likely to reach the outer bands. Conversely, in low volatility periods, the bands contract, indicating a decrease in potential price movement.
  5. Support and Resistance: Bollinger Bands can be used to identify support and resistance levels. The middle band often acts as a dynamic support or resistance, while the upper and lower bands may act as dynamic areas of resistance and support, respectively.
  6. Trend Reversals: Bollinger Bands can also help identify potential trend reversals. When the price approaches or touches the upper band, it may indicate an overbought condition, suggesting that the price might reverse downward. Similarly, when the price approaches or touches the lower band, it may suggest an oversold condition and a potential reversal upward.

It is essential to note that Bollinger Bands are not a standalone indicator and should be used in conjunction with other technical analysis tools and indicators to provide a more comprehensive understanding of market conditions.

What are the dangers of relying solely on Bollinger Bands for trading decisions?

While Bollinger Bands can be a useful tool for traders, solely relying on them for trading decisions can be risky due to various reasons:

  1. Misinterpretation of Signals: Bollinger Bands are based on standard deviations, which measure volatility. However, high volatility does not always imply a reversal or change in the direction of price movement. Overreliance on Bollinger Bands can lead to false signals or misinterpretations.
  2. Limitations in Trend Identification: Bollinger Bands are primarily used to identify overbought and oversold conditions in the market. But, they may not be effective in determining the strength or sustainability of a trend. This limitation can result in missing out on profitable trend continuation opportunities.
  3. Ignoring Fundamental Analysis: Bollinger Bands are primarily a technical analysis tool and do not consider fundamental factors that can impact a market, such as economic news, political events, or company-specific news. Relying solely on Bollinger Bands neglects the importance of understanding the fundamental aspects of trading.
  4. Market Conditions: Bollinger Bands are more effective in trending markets where prices consistently move within a specific range. In choppy or sideways markets, Bollinger Bands may not provide accurate signals. Depending solely on Bollinger Bands during such market conditions can lead to losses.
  5. Lagging Indicator: Bollinger Bands are a lagging indicator, meaning that they are based on historical price data. This characteristic can result in delayed signals, often causing traders to enter or exit positions too late, missing potential profit opportunities or increasing the risk of losses.
  6. Lack of Confirmation: Bollinger Bands should ideally be used in conjunction with other technical indicators or analysis techniques to confirm signals. Relying solely on Bollinger Bands without cross-referencing other indicators or patterns can lead to false signals and increase the risk of making poor trading decisions.

It is important for traders to balance the use of Bollinger Bands with other analysis tools and consider the market conditions and fundamental factors before making trading decisions.

How to use Bollinger Bands for mean reversion trading?

To use Bollinger Bands for mean reversion trading, follow these steps:

  1. Understand Bollinger Bands: Bollinger Bands consist of three lines – the middle band (typically a 20-day simple moving average), an upper band (usually two standard deviations above the middle band), and a lower band (two standard deviations below the middle band). These bands help identify overbought and oversold conditions in the market.
  2. Identify overextended prices: Look for instances where the price of the security you are analyzing has moved too far away from the middle band, creating situations of overbought or oversold conditions. When the price reaches the upper band, it implies the security is overbought, and when it reaches the lower band, it indicates it is oversold.
  3. Wait for confirmation: Mean reversion trading aims to capture the price returning to its average or mean value. Therefore, it is crucial to wait for confirmation signals before entering a trade. Look for additional indicators or patterns that confirm the likelihood of the security reverting to its mean.
  4. Enter trades based on signals: Once you have identified an overbought or oversold condition and received confirmation signals, enter a trade based on your strategy. For example, if the price is over the upper Bollinger Band, indicating an overbought condition, you can consider shorting the security, expecting the price to revert back towards the middle band.
  5. Set appropriate stop loss and take profit levels: As with any trading strategy, it is important to set stop loss and take profit levels to manage risk. Determine appropriate levels based on your risk appetite and incorporate them into your trading plan.
  6. Monitor the trade: Keep track of the trade and watch for signs of the price reverting towards the mean. Bollinger Bands can help indicate potential turning points or reversal patterns. If the price starts moving back towards the middle band, you may consider closing the trade and taking profits.

Always remember that no trading strategy is foolproof, and it is essential to conduct thorough analysis, practice risk management, and refine your strategy based on market conditions and experience.

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