- Basic terms and working of Bollinger Bands.
- Predicting price movements.
- Caution while using Bollinger Bands.
Bollinger bands measure the volatility shown by a given security. Bollinger band uses standard deviation to show the change in volatility and move above and below the Simple Moving Average (SMA). Bollinger bands trading strategy differs from trader to trader and is generally used in combination with other tools. It is important for every trader to understand how to use Bollinger bands to find the ideal entry/exit points of trade.
Basic Terms And Working
We look at the working of Bollinger Bands through an example of Google’s stock.
Fig: Google’s price movement in the past few months. Green line is the SMA line, purple is the upper band and blue line is the lower band of the Bollinger bands
SMA: The green line in the middle is the simple moving average. Generally a 20-period time length is used by traders. However for longer or shorter duration trades this time length can be modified.
Upper Band: Bollinger bands consist of an upper band which is the purple line on the chart. This moves along the SMA with actual values equal to SMA + 2 * Std. Dev.
Lower Band: This is the band shown in blue. It also moves along the SMA with values of SMA – 2* Std. Dev.
Standard Deviation: Standard deviation is a statistical measure which calculates the volatility in a given set of numbers. We can understand it through a simple diagram:
Fig: Standard deviation breakup of values.
In the above figure the middle X values shows the mean of all the values which are considered. Statistically, within 1 standard deviation of the mean 68.26% of values will be contained. Within 2 standard deviations 95.44% of the values will be covered and within 3 S.D more than 99% of all the values will be covered.
By taking 2 standard deviations within the Bollinger bands we have tried to encapsulate over 95% of price movements. That means there is a probability that 95% of the time the price values of a security will fall within the upper and lower Bollinger bands. (However, as John Bollinger himself stated in actual markets 2 standard deviations covers about 89% of price movements). When a price falls below the lower band it can be a sign of the market being oversold and similarly when the price rises above the upper band it can be a sign that the market is overbought. Both of them can result in a correction giving profitable trading points.
Band Thickness: When the volatility of the security is less the band constricts. Within Google’s stock movement this is depicted in point 1 and 3. When the price fluctuates widely there is an increase in the volatility of the security. At this time the band expands as can be seen at point 2 in the figure 1. This contraction and expansion is an important aspect of Bollinger bands trading strategy as it helps in finding the volatility of the price fluctuations and overall momentum.
Predicting Stock Price Movements
Figure: Predicting IBM’s price movement through Bollinger bands
At point 1 there is a huge overshooting of the upper band by the stock. The stock continues its upward trend till point 2. However although point 2 is a “higher high” in terms of the absolute price level for the stock the Bollinger band shows that this price level is easily contained within the upper band. This is an early sign that the stock is losing its upward momentum. At the next pullback at point 3 the stock price is much lower than the upper band and this is a clear sign that a bearish trend is about to take place. Hence by comparing 1-2 and then comparing 2-3 the Bollinger bands give an unmistakable sign of making a profitable trade.
Most of the traders who know how to use Bollinger bands and Relative Strength Index end up combining both the indicators to cross compare if the sign predicted by one is confirmed by the other signal.
Caution While Using Bollinger Bands
Bollinger bands are a very powerful tool but they need to be carefully analyzed. Just because a security has overshot the upper band does not mean that it will show a bearish trend. It takes a lot of strength within the price movement to overshoot the bands and there must a strong reason why this is shown. Around 9 out of 10 times the price level will be contained within the bands and hence any price level outside the bands is due to specific macro or company specific events. In such cases the trend must be closely watched to find the ideal entry/exit points.
Sometimes the price end up “walking the band”, that is they continuously touch the upper or lower bands during a strong bullish/bearish trend.
Fig: Apple’s stock showed a long bullish trend where the price was continuously above the SMA line and crossing the upper band.
Bollinger bands have shown good returns in actual trading. They are one of the primary tools used by traders, however depending on the type of security and the level of trade, modifications must be made in their use. They are ideal when used in combination with other tools which can point any false signs shown by Bollinger bands.