Bollinger Bands
Definition¶
The Bollinger Bands is a popular indicator designed to measure market volatility by considering the Simple Moving Averages (SMA) and the Standard Deviation (SD). Bollinger Bands appears on a chart in the form of three lines.
History¶
John Bollinger, a well-renowned financial analyst, developed the Bollinger Bands in the 1980s. Bollinger then detailed his work in his book ‘Bollinger on Bollinger Bands’, published in 2001. The book explains the theory behind the bands as well as their applications in detail. The Bollinger Bands are often displayed on top of the price chart, as a result, there are instances where the prices may touch top and bottom Bollinger bands.
Calculations¶
The Bollinger Bands consists of 3 lines:
- Middle band. Defined as a moving average over the specified period, using the source price data.
\[ Main = Moving\ Average\ (Price, Periods) \]
- Top band. Determined by adding the deviation shift to the middle band.
\[ Top = { Main + Deviation\ Shift } \]
- Bottom band. Determined by subtracting the deviation shift from the middle band.
\[ Bottom = { Main - Deviation\ Shift } \]
The deviation shift is calculated by multiplying the Standard Deviation of the price data over the same period by the multiplier (typically 2):
\[ Deviation\ Shift = SD \times k \]
Interpretation¶
By default, the Simple Moving Average over a 20-period is used to calculate the moving average value. However, it can be adjusted based on the trader strategy and the timeframe of analysis.
The main patterns of the indicator behaviour can be interpreted as follows:
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Breakouts. A close above the top band may indicate strong bullish momentum. A close below the bottom band may indicate strong bearish momentum.
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Divergence. If the price makes new highs or lows while the bands do not follow, it may indicate weakening momentum.
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Shift. By adjusting the shift parameter to alter the alignment of the Bollinger Bands with price data on the chart, you can explore how the indicator readings correspond to past or future price movements.
Application¶
The Bollinger Bands can be used in several trading strategies to identify volatility and potential market direction.
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Buy signals. Traders may consider entering buy positions when the price touches or exceeds the bottom band, indicating oversold conditions. A confirmed reversal can signal a good entry point.
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Sell signals. A sell signal may occur when the price touches or exceeds the top band, indicating overbought conditions and a potential reversal.
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Stop-loss placement. Traders can use the Bollinger Bands to set a stop loss at or near the top or bottom bands, depending on their market position, to manage risk.
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Exit strategies. If prices close above or below the bands and then retreat back within them, it may signal that the momentum is weakening and traders might consider exiting positions.
Note
You can take advantage of algo trading, with cBots executing trades based on the signals from this indicator, as shown in our examples. Learn more about how to use indicators in cBots.
Limitations¶
The Bollinger Bands may lag behind fast-moving markets. Additionally, because they are sensitive to volatility, the bands may either understate market movements in low-volatility conditions or exaggerate them in high-volatility environments.
Summary¶
The Bollinger Bands are a powerful indicator, helping traders identify the price volatility of an asset by calculating its simple moving average as well as its standard deviations. The indicator consists of three bands; the middle one indicates the SMA and the top and bottom ones count for a specified number of standard deviations to identify potential bullish or bearish momentums.