Key Takeaways
- Bollinger Bands® use a moving average with two price bands above and below, indicating volatility through expansion and contraction.
- The bands consist of a centerline, typically a simple moving average, and two price channels representing standard deviations.
- Prices touching the upper band can signal an overbought market, while touches to the lower band may indicate an oversold condition.
- Traders use Bollinger Bands® to set price targets; the upper and lower bands are often considered potential market turning points.
Bollinger Bands® should be used alongside other indicators as they are not reliable as a standalone tool.
Bollinger Bands® were developed by John Bollinger to help traders analyze market trends. They consist of a centerline, a moving average, and two price channels that sit above and below it to reflect market volatility. Traders use them to identify potential overbought or oversold conditions, helping forecast possible price movements. These bands are often used with other technical indicators for more accuracy, providing a better picture of market conditions and stronger signals.
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How Bollinger Bands® Work
Bollinger Bands® have a centerline with two bands, one above and one below. The centerline is usually a simple moving average, and the bands are standard deviations of the stock. The bands widen with volatility and contract in tight trading patterns.
A stock may trade for long periods in a trend, albeit with some volatility from time to time. Traders use the moving average to better see the trend in price action. This way, they can gather important information about how the market is moving. For example, after a sharp trend change, the market may consolidate and trade narrowly around the moving average. To better monitor this behavior, traders use the price channels, which encompass the trading activity around the trend.
We know that markets trade erratically on a daily basis, even though they are still trading in an uptrend or downtrend. Technicians use moving averages with support and resistance lines to predict stock price movement
Important
Technical analysis is a trading strategy that analyzes statistical trends to identify trading opportunities.
How to Use Support and Resistance Lines with Bollinger Bands®
Traders draw upper resistance and lower support lines to form expected price channels. Some traders connect price tops or bottoms to set upper and lower limits, then draw parallel lines to define the price channel. If prices stay within this channel, traders can be confident that their expectations are met.
Stock prices that touch the upper band are seen as overbought, while those touching the lower band are seen as oversold, triggering buy signals.
When using Bollinger Bands®, treat the upper and lower bands as price targets. If the price deflects off the lower band and crosses above the 20-day average (the middle line), the upper band comes to represent the upper price target. In a strong uptrend, prices usually fluctuate between the upper band and the 20-day moving average. When that happens, a cross below the 20-day moving average warns of a trend reversal to the downside.
Real-World Examples of Bollinger Bands® in Action
The chart below is of American Express (AXP) from the start of 2008. You can see that for the most part, the price action was touching the lower band and the stock price fell from the $60 level in the dead of winter to its March position of around $10. In a couple of instances, the price action cut through the centerline (March to May and again in July and August), but for many traders, this was certainly not a buy signal as the trend wasn’t broken.
In the 2001 chart of Microsoft (MSFT) below, you can see the trend reversed to an uptrend in the early part of January. But take a look at how slow it was in showing the trend change. Before the price action crossed over the centerline, the stock price moved from $20 to $24 and then on to between $24 and $25 before some traders would have confirmation of this trend reversal.
This is not to say that Bollinger Bands® aren’t a well-regarded indicator of overbought or oversold issues, but charts like the 2001 Microsoft layout are a good reminder that we should start out by recognizing trends and simple moving averages before moving on to more exotic indicators.
What Are Bollinger Bands®?
Bollinger Bands® are tools used in technical analysis. They were designed by John Bollinger, a technical trader. The bands are used to generate signals for securities that are oversold or overbought. The bands are composed of different lines that are plotted on a chart, including the moving average, an upper band, and a lower band.
What Do Bollinger Bands® Tell You?
Bollinger Bands® are highly technical tools that give traders an idea of where the market is moving based on prices. It involves the use of three bands—one for the upper level, another for the lower level, and the third for the moving average. When prices move closer to the upper band, it indicates that the market may be overbought. Conversely, the market may be oversold when prices end up moving closer to the lower or bottom band.
Are There Any Limitations to Bollinger Bands®?
Yes. One of the main limitations is that it shouldn’t be used as a standalone tool. In fact, Bollinger Bands® should be used with other non-correlated indicators. Doing so may give you additional market signals that are much more direct. Another drawback is that they are calculated using a simple moving average. That’s because older price data is weighted in the same way as recent data.
The Bottom Line
Bollinger Bands® are a popular technical analysis tool used to identify overbought or oversold conditions in securities. They consist of a centerline, a simple moving average, and upper and lower bands set by standard deviations. Traders often look for buy signals when prices dip below the lower band and potential sell signals when prices rise above the upper band, using the centerline as a reference for price trends. While Bollinger Bands® are valuable for spotting short-term price extremes, they have limitations and work best when combined with other non-correlated indicators for a fuller view of market conditions.