Bollinger Band Definition & Example


What Is a Bollinger Band?

Bollinger Band is used in technical analysis and demonstrates expected volatility of an asset. The indicator is based on three bands / lines. In the middle there is a moving average (usually 20 days) whereupon an upper and a lower band are drawn based on standard deviation for 20 days multiplied by 2 and -2 respectively.

According to the theory, buying positions occur when the price is close to the lower band and thus sales position when the price approaches the upper band. In addition to this, there are also buy and sell signals when the price breaks these bands (passes them).

How to calculate Bollinger bands

Bollinger bands are usually calculated based on the last 20 days of trading. This is the industry standard that can be modified according to your own wishes.

Since Bollinger Bands consists of 3 different plotted lines, here you see how you can calculate each of these bands.

  • Middle Bollinger Belt (Simple Moving Average) = Average of the closing price over the last 20 days
  • Upper Bollinger Belt = (Average of the final price for the last 20 days) + (2 standard deviations from the 20-day price)
  • The bottom Bollinger Band = (The average of the final price over the last 20 days) – (2 standard deviations from the 20-day price)

This is how the Bollinger Band works

Most trading tools can automatically apply Bollinger Band to a trading view. There is thus nothing that you need to calculate and apply yourself to be able to use. However, you should fully understand how it is calculated – this, like all other aids in technical analysis.

Bollinger Band consists of three “bands” (lines) that are placed over an asset’s price chart.

Moving average

First, a moving average (SMA) is placed. The most common is that the moving average for 20 days is used. This will be the middle line of the three lines that make up the Bollinger Band.

Moving 20-day average = Total sum of last 20-day course / 20

Depending on how long the trading takes place, a shorter or longer period for moving averages can be used. The important thing is that the other two bands are also calculated with the same time period.

Upper and lower straps

Then an upper and lower band are placed. These are placed with usually 2 standard deviations from SMA. It is these that thus become areas of support and resistance.

Standard deviation for 20 days multiplied by 2

The upper band will thus follow the moving average + 2 standard deviations, while below the band follows the moving average – 2 in standard deviation.

It is sometimes recommended that -2.5 in standard deviation is used at a 50-day moving average and that it is lowered to 1.5 at a 10-day moving average.

Correct based on the development of the asset

As shown in the picture below, the course reaches both the lower and upper band several times during the measurement period. Thus, it is set correctly based on the development of the asset.

Basically, x2 can be used as a standard deviation, but then adjustments can be made so that the bands act as guidelines for the historical development. Then the same settings can be used in the future.

Disadvantages of Bollinger Bands

Bollinger Bands should usually be used with other indicators as they often do not provide enough information about the price movement to be used as an input signal.

John Bollinger himself, the creator of Bollinger Bands, recommends not using Bollinger Bands on your own.

Bollinger Bands has many inherent limitations, and I’ll take you through one of the biggest one next.

The simple moving average problem

Bollinger Bands are based on a simple moving average, which presents one of the most obvious problems with charts. An SMA gives equal weight to the price of the product / instrument 20 days ago as it did with its price yesterday.

In most cases, data from almost three weeks ago will have a much smaller impact on the price than the data from the last week.

This means that there is no way to ensure that data from Bollinger Bands that are important have not been “diluted” with data that is largely insignificant.

What do the bands show?

1. Normal market volatility

Bollinger Band is used in technical analysis to demonstrate what volatility an asset can be expected to have.

If there is a long distance between the bands, this means that a large volatility can occur without it having to involve either a buying or selling position. Volatility within the bands is “normal”.

2. Discover trend / outbreak

A new trend (whether it is up or down) generally increases the volatility of a market. If the bands are drawn closer to each other, this means lower volatility.

If this persists over a period, it may indicate an upcoming trend / outbreak. When this happens, increased volatility will thus increase the distance between the bands.

3. Purchase mode

When the course is around the lower band, there is an expectation that a certain correction of the course will take place.

In this mode, the course around the upper band can also be used as a guiding course.

Another buying situation arises if the price “stands and strikes” on the upper band. It’s like the course wants to pass the band but has not really succeeded yet.

There are also analysts who buy when the price has “broken out” and thus gone over the upper band.

4. Sales mode

When the price is around the upper band, there is an expectation that a downward correction will occur, which means a sales position.

Some analysts also see that the asset should be sold if the price breaks below the lower band.

5. Breaks the band

If the course breaks the ties, the course is expected to continue in this direction. In this case, the course has broken a support and seeks new support levels.

Criticism on Bollinger Bands

1. Lagging analysis

Since the Bollinger Band is based on a 20-day moving average and a 20-day standard deviation, a “trailing” analysis is created.

When changes affect the Bollinger Band, it may already be “too late” to act.

2. Self-fulfilling prophecy

One criticism that is usually made, against all analyzes in technical analysis, is the “self-fulfilling prophecy”. Analysts follow an asset and see that the price is at the lower band.

They then buy the asset because the theory with Bollinger Band shows a coming rise.

This in itself creates a buying pressure which will push up the price.

The many believe in – will happen. This is based on the fact that the analysts act on the basis that it is a truth. But it will only be a self-fulfilling prophecy.

3. Cannot be used alone

Bollinger Band should never be used as a single indicator that an asset should be bought / sold.

However, the theory can be used to consolidate or deny an idea about future development.

Since it is generally mentioned that the theory needs the support of other analyzes, it is also very difficult to prove / disprove its function.

Bollinger bands in practice

Bolliger bands can, for example, be used to find a so-called “squeeze” scenario. The scenario means that the bollinger bands are contracted due to a low-volatile period and may signal that a larger movement is underway.

However, the tool cannot be used to place a trade as the tool does not provide any form of signal when this major movement is expected to occur.

Sold / overbought

Bollinger bands are commonly used to find overbought and oversold scenarios that can be used to make decisions about whether to start or end a trade.

The closer the price is to the upper band, the more overbought it is considered to be, and vice versa in the lower direction.

Does this Bollinger Band indicator work?

Several studies have been carried out to determine whether the Bollinger Band is such a strong indicator that it can be used as a separate buy and sell indicator.

The results have been both positive and negative.

For example, there is a study from 2007 where analyzes were carried out on share prices from 1995 onwards.

The results showed that those who chose “buy and hold” had received better returns than those who bought and sold based on the indicators provided by Bollinger Band.

However, the study also showed that those who had applied reverse Bollinger Band (opposite Bollinger Band) would have received a greater positive return in several markets.

Another study, from 2012, showed the importance of adapting the parameters within the Bollinger Band to the specific market.

By doing this, instead of just following the basic settings, better returns could be achieved.

In defense of the theory, it should be added that its founder, John Bollinger, said that the analysis tool should be used with other indicators and thus not be used as a single indicator.

Bollinger Band Concepts

Bollinger Squeezes

The distance between the upper and lower bands decreases, which means that both bands come closer to the moving average. Volatility has thus decreased and this may be a sign of an impending “eruption”.

Bollinger Bounces

The distance between the upper and lower bands increases, which means that the band comes lower from the moving average. Volatility has increased in the market.

Bollinger Bands are dragging

Anyone who uses Bollinger Bands can see that the bands only react to the price movements. They do not predict the future price in any way.

As such, there is no fixed formula on which you can base your predictions and you must design your own strategy to respond to the changes in Bollinger Bands.

When you connect this with the mentioned fact that all periods in an SMA are equally weighted, it is quite obvious to see that Bollinger Bands would have a limited use in extremely speculative markets as the price would depend more on news and extremely short-term trends as opposed to the price in the last 20 days.

Conversely, Bollinger Bands work best when the market is stable and prices are moving gradually.

Indicators to combine with Bollinger Band

John Bollinger (the founder of Bollinger Band) has pointed out that an analysis of an asset should not be done with the help of these bands alone.

Examples of other indicators that can be used together are, for example:

  • RSI – (Relative Strength Index) Indicates the development of the asset in relation to its historical development during a predetermined period.
  • MACD – (Moving Average Convergence Divergence) Demonstrates divergence / convergence based on the moving average and thus changes in the asset’s momentum. MACD is based on several different averages and is used to find support and resistance levels.

Conclusion

Bollinger Bands are a fantastic statistical tool that can be extremely beneficial to investors as it can help determine market entry, short-term highs and lows in a trend and stop-loss price.

However, it has its drawbacks and should be used in conjunction with other indicators to maximize its effectiveness.

Sources

https://www.sciencedirect.com/science/article/abs/pii/S156849461500174X

https://ieeexplore.ieee.org/abstract/document/6327770

https://www.tandfonline.com/doi/abs/10.1080/00036846.2016.1142653

https://www.proquest.com/openview/4800ce4e8d5afefaa739725e338046b9/1?pq-origsite=gscholar&cbl=2030941

https://arxiv.org/abs/1212.4890

https://www.indianjournals.com/ijor.aspx?target=ijor:ijmss&volume=3&issue=6&article=024

https://lutpub.lut.fi/bitstream/handle/10024/158793/Thesis_lehtoalho_jaakko.pdf?sequen

https://dl.acm.org/doi/abs/10.1145/3436829.3436869

https://www.ejurnalunsam.id/index.php/jseb/article/view/2467

https://www.sciencedirect.com/science/article/abs/pii/S0378437106003712

Kevin

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