Basic Guide to Bollinger Bands

Basic Guide to Bollinger Bands

Bollinger Bands, abbreviated as BB, are a highly popular technical indicator developed by John Bollinger, CFA, CMT, used to measure market volatility. This indicator consists of three lines: a moving average (MA) line and two lines above and below the MA calculated based on the MA and price volatility in the past. These three lines never intersect, so the two lines above and below the indicator move like a band.

Construction Formula of Bollinger Bands

Similar to many other indicators, Bollinger Bands can be customized by two parameters (m, n). Firstly, the basic component of the Bollinger band is a central MA line (m), typically the 20-period Simple Moving Average (SMA). Then, at any given point, we calculate the standard deviation of a set of price data of m candles, including the current candle and the previous m – 1 candles, as follows (if you haven’t studied this subject, you only need to remember the formula below):

Basic Guide to Bollinger Bands

Where: σ is the standard deviation, Ai are the price data in the m candles under consideration, Ᾱ is the mean value of those m price data.

From the MA line and standard deviation, we can construct the upper and lower bands using the following formulas:

Upper Band = MA + nσ
Lower Band = MA – nσ

Most commonly, the two upper and lower bands of the Bollinger Bands indicator are calculated by adding or subtracting 2 times the standard deviation (i.e., taking n = 2). In this case, about 90% of the price levels are expected to fall within this Bollinger band range.

Characteristics of Bollinger Bands

Bollinger Bands are a widely used technical indicator. Many traders believe that as the price approaches the upper band, the market shows overbought conditions, and as the price approaches the lower band, the market shows oversold conditions.

Standard deviation is calculated to construct Bollinger Bands. In essence, standard deviation is a measure of price volatility, with larger standard deviations indicating greater price volatility, thus expanding the width of the Bollinger Bands. Conversely, the Bollinger Bands will contract during periods of low market volatility.

The Bollinger Bands indicator is constructed from an MA line, and similar to the characteristics of the MA line, Bollinger Bands are also classified as lagging indicators.

Using Bollinger Bands in Technical Analysis

The BB indicator (20, 2) typically contains about 90% of price data. Therefore, price signals breaking out of the band range may be noteworthy. However, these breakout signals are not necessarily considered reversal trading signals; many traders believe they could indicate trend continuation. When the BB bands contract, signaling reduced market volatility and entering a consolidation phase, many investors expect a signal of the bands expanding again, indicating a resumption of the trend. However, this is also difficult to consider as a buy or sell signal, as the BB indicator does not provide any information about when market volatility will increase again or which direction prices will move.