Understanding the Bollinger Bands

Introduction

A very popular and widely used technical indicator are the Bollinger Bands, developed by John Bollinger. The indicator is used to measure the volatility of a stock or any other financial instrument. The indicator is a derivative of another well-known and very popular technical indicator, the Moving Average.

By volatility we mean the degree of movement. If the price of an underlying asset (stock, index, ...) is fairly stable and there are no significant movements up or down, we will refer to it as low volatility. If the degree of volatility is high and prices move sharply up and down, we are talking about high volatility. Of course, this is not a constant. Sometimes stocks can have high volatility and sometimes not.

A typical example is often seen in the stock price just before the company releases important news, quarterly results for example. This almost always results in high(er) volatility because of the uncertain outcome. Certain market participants assume good results and thus a positive effect on the share price, others think there could be a negative effect. Because the participants want to position themselves in the market, there is a certain nervousness that makes the share price go up and down, faster than usual.

How to read this indicator correctly?

The indicator itself consists of three lines. The middle line is a simple moving average and above and below that are then the upper and lower bollinger bands.

The simple moving average is set by default to a period of 14 trading days, however, you can easily change this to any other time period. A standard deviation (multiplier 2) is used to derive the upper and lower bollinger band from the moving average. How exactly this standard deviation is calculated would take us too far. By the way, that’s not necessary to use this indicator. What is important to remember is that the upper and lower bollinger bands are dynamic and that previous statistical research has shown that the price will fluctuate within them 80% to 95% of the time.

A first visual and simple application of the bollinger bands is based on the distance between the upper and lower bands. If they widen, it means that volatility is increasing. However, if they run towards each other, this is evidence that volatility is decreasing. The faster this happens, the more extreme the movement (volatility) is. Ideal for those looking for stocks with a high degree of volatility and momentum, with the intention of profiting from the often short but violent price fluctuations. Of course, everything depends on your investment style and strategy. A calm dividend investor is more likely to disregard such stocks.




If price now suddenly moves above the upper- or below the lower bollinger band, this is a very good indication of a price extreme. But some caution is needed with that. There is a big difference when that price extreme occurs at high or low volatility. We'll illustrate this with two examples in our stockscreener.

Example 1

The price rises above the UBB (Upper Bollinger Band) at low volatility (upper and lower bollinger bands converge or are quite close together). Often you see that in this situation the price has been in a sideways range for some time. This is the ideal situation for a price breakout.



Example 2

price also quotes above the UBB (Upper Bollinger Band) at high volatility (distance between upper and lower bollinger band is widening or is already large). Typical here is that the price has been rising for a while. Under these circumstances buying at a price breakout is riskier.



From the examples above, it should be clear that a price extreme above the upper or below the lower band should always be considered in conjunction with the distance between that upper and lower band.

Adding Bollinger Bands to your chart as an indicator or overlay in our charts or screener

Via the stockcharts page you can add the Bollinger Bands to your chart (first click on the blue 'plus' sign to add an indicator or overlay). By default you use the option 'overlay' and then select 'Bollinger Bands'. The 'look back period' is set to 14 days but you can change this if you need to.



The indicator option allows you to select the ‘Percent Bollinger (%B)’. This indicator quantifies the price of the stock relative to the Bollinger Bands. The 'look back period' can also be adjusted here.



Finally, there is the possibility to plot the distance between the upper and lower bollinger bands as an indicator below the price chart. To do so, choose the option 'indicator' and then look for the option 'Bollinger Bands Width' in the drop down menu. The 'Bollinger look back period' as well as the 'average look back period' can be set separately if desired.



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