Bollinger Bands Explained

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 (the degree of movement) of a stock or any other financial instrument.

To accomplish the above, the Bollinger Bands consist of three components:

The center line: a simple moving average of price.
Upper Bollinger Band: plotted as a standard deviation level above the center line.
Lower Bollinger Band: plotted as a standard deviation level below the center line.

As the upper and lower Bollinger Bands are both based on a standard deviation from the center line they will adjust for fluctuations in the underlying price.

Bollinger Bands Width

The bandwidth in Bollinger Bands play an important role in visualizing the degree of volatility.

(Band Width = (Upper Bollinger Band - Lower Bollinger Band) / Center Line)

A high bandwidth is an indication that price movements are fierce and thus volatility is high.
A low bandwidth indicates low volatility and shows that the price is moving rather quietly sideways in a narrower price channel.

Bollinger bands expension and contraction

A strong downtrend (blue box left) will cause the lower bollinger band to be persistently crossed for an extended period of time. The longer this period lasts the more likely it is that the end of the trend is in sight.

When the price moves rather sideways and the distance between the upper and lower bollinger bands narrows sharply (blue box right), it is an indication that a larger move in either direction may be about to occur.

Bollinger Bands Strategies

The Squeeze Play - Breakout setup

The Bollinger Bands Squeeze occurs after a period of low volatility where the upper and lower bollinger bands are squeezed closely together, so to speak.

As visible on the chart, the price moves sideways in a tight trend channel. This squeeze is used as part of a breakout strategy where traders go long or short as soon as the price closes above or below the upper/lower bollinger bands.

Trend Continuation - Pull back setup

Trading when the stock undergoes a small price decline in the direction of the main trend (pull back or retracement setup) is a common strategy in which Bollinger Bands are used. In the example below the trend changes to positive once a breakout above the ascending triangle occurred and the first higher high and higher low were confirmed.

In that case, the centerline or lower bollinger bands can be used as target points where opportunities may present themselves to enter the market and benefit from the existing long-term trend.

Bollinger Band Reversals - mean reversion setup

Bollinger bands can just as easily be used as part of a mean reversion strategy. We mentioned earlier that when volatility is high and the bandwidth is wide, the probability increases that the existing trend will lose momentum and eventually reverse.

It is important not to take an opposite position simply because the distance between the upper and lower bollinger bands is large or because price has hit or broken a bollinger band several times in a row.

Always keep in mind that these are mere indications and not isolated trading signals.

Additional converging elements such as, for example, the reversal occurring at an earlier support or resistance level are very important to strengthen the hypothesis of a reversal before taking the trade.

Bollinger Band Filters in ChartMill

ChartMill allows you to apply filters that use the Bollinger Bands. These can be found under the 'indicators' menu on the stock screener page.

Multiple filters are available. For example, you can specify that the most recent closing price should be above the upper bollinger band or below the lower bollinger band, or you can search specifically for stocks which are maximum 2 or 5% away from one of the two Bollinger Bands. These are default values which can be deviated from by using custom filters.