Bollinger Bands: What They Are, and What They Tell Investors

Bollinger Bands, a popular tool among investors and traders, helps gauge the volatility of stocks and other securities to determine if they are over- or undervalued. Developed in the 1980s by financial analyst John Bollinger, the bands appear on stock charts as three lines that move with the price. The center line is the stock price's 20-day simple moving average (SMA). The upper and lower bands are set at a certain number of standard deviations, usually two, above and below the middle line.

The bands widen when a stock's price becomes more volatile and contract when it is more stable. Many traders see stocks as overbought as their price nears the upper band and oversold as they approach the lower band, signaling an opportune time to trade.

While valuable, Bollinger Bands are a secondary indicator that is best used to confirm other analysis methods. Below, we guide you through how to interpret Bollinger Bands, when the tool is best used, and what other indicators are best matched with it.

Who Is John Bollinger?

John Bollinger, CFA, CMT, has been a major influence in technical analysis and is best known for developing Bollinger Bands in the 1980s. Bollinger combined his background in mathematics and engineering with financial market analysis to create this tool, which uses a moving average and the statistical measure of standard deviation to assess the volatility and trends of stock prices. The tool has since become a staple in technical analysis. He is also the founder of Bollinger Capital Management, a money management company, and has been a prominent commentator and analyst on market conditions.

Constructing Bollinger Bands

The three lines that make up Bollinger Bands are based on a security's price moves. The center line is the intermediate-term trend and is typically a 20-day SMA of the closing prices. The upper and lower bands are plotted a distance from the SMA set by a certain number of standard deviations, usually two, above and below the center line.

To calculate the bands, you first determine the number of periods used for both the SMA and standard deviation, and the number of standard deviations for the upper and lower bands should be from the center line. While the settings can be adjusted based on your strategy, most times, you would use a 20-day SMA and two standard deviations.

The upper band is found by adding two standard deviations to the center SMA line, while the lower band is calculated by subtracting two standard deviations from the center line. The bands automatically widen when price volatility increases and narrow when volatility goes down.

You don't need to break out your calculator and graph paper: Many popular trading platforms, like TradingView, include this technical indicator as a standard feature. Thus, you can easily overlay Bollinger Bands onto price charts. You can also usually customize the Bollinger Bands' settings (increasing or lowering the periods and standard deviations) to fit your needs.

Given that the bands are plotted two standard deviations away from the SMA, they can indicate when prices are statistically high or low. Many traders consider the area near the upper band to be overbought territory—the price is poised to fall—and a potential resistance level where sellers may step in. Conversely, the area near the lower band is often seen as oversold—the price is poised to go up—and a potential support level where buyers could enter the market.

How To Trade With Bollinger Bands

Option traders and investors use Bollinger Bands to assess market volatility and identify potential entry and exit points. The tool is premised on the idea that prices tend to remain within the bands' upper and lower limits.

One use is for trend analysis. The direction of the middle band can indicate a trend's strength: when the middle band is heading upward, this suggests an uptrend, and the converse when heading downward. In addition, the width of the bands reflects market volatility. Narrow bands indicate less volatility, which means a significant price move could be imminent. This is known as a "squeeze." Conversely, wide bands indicate more volatility.

Another way to use the tool is to figure out when an asset is overbought and oversold. As the price touches or moves outside the upper band, it could be overbought, suggesting a potential selling or short opportunity. Similarly, if the price touches or falls outside the lower band, the asset may be oversold, indicating a possible buying opportunity.

The bands can also help find price targets. For instance, after a price "bounces" off the lower band, the upper band becomes a potential exit point if the price trend reverses. Likewise, after a price move that touches the upper bands, the lower band becomes a possible target if a reversal occurs.

Another strategy is called the "Bollinger Bounce." This is based on the idea that prices tend to return to the middle band. Traders may buy or sell based on the rebound from the upper or lower bands toward the middle band, especially in a ranging market.

Below is a table of different ways the Bollinger Bands can move, what they indicate, and how traders often react. We then go through these moves in more detail so you understand the strategies better.

Moves Within the Bands

Using two standard deviations in constructing Bollinger Bands is based on the statistical properties of the normal distribution and the concept of volatility. In this context, standard deviation measures how far prices typically deviate from SMA, the middle band.

By setting the upper and lower bands two standard deviations away from the SMA, Bollinger Bands create a range expected to contain approximately 95% of the security's price movements over a given period. This assumption is based on the statistical rule that about 95% of the data points will fall within two standard deviations of the mean for a normally distributed data set. Choosing two standard deviations provides a statistically significant measure of volatility while remaining practical for market analysis. The bands can adapt to changes in volatility, making them suitable for various market conditions.

When prices move outside the upper or lower bands, this suggests that the security is trading at a statistically high or low level relative to its recent price history. This indicates potentially overbought or oversold conditions, respectively. However, prices can remain outside the bands for extended periods during strong trends.

Signals at the Upper Band

By examining the relationship between the price and the upper band, you can look for overbought conditions, check for potential price reversals or a slowdown in momentum, find out when volatility is expanding, set price targets based on mean reversion strategies, and determine the strength of a trend.

When the price touches or pushes through the upper band, this is often read as the security is overbought. This is because the asset is priced higher than its typical valuation range, indicating a potential reversal or slowdown in momentum.

When the price reaches or goes above the upper band, this indicates increased volatility. Since Bollinger Bands adjusts to volatility, a widening gap between the upper and lower bands means that the market is experiencing wider price fluctuations, which could be due to economic and market news, earnings reports, and other market events.

For investors using mean reversion strategies, the upper band can act as a price target in a ranging market. If the price oscillates between the upper and lower bands without a clear trend, hitting the upper band can signal to sell or go short because traders expect the price to move back toward the middle band or below.

In addition, when there's a strong uptrend, the price might repeatedly touch or stay above the upper band for extended periods. This persistence above the upper band might indicate strong buyer enthusiasm and signal that the trend is likely to continue. However, traders and investors often look to confirm this with other indicators or techniques.

The upper band can also be the site for a breakout. A price move that starts at the upper band and continues to push outside of it can signal one, especially if there's been an increase in trading volume. This indicates that the asset is starting a new trend or accelerating an existing one. You could use this signal to trade in the direction of the breakout.

Signals at the Lower Band

The lower band of the Bollinger Bands helps identify oversold conditions. It is also a reference line for those using mean reversion strategies or looking for potential reversals. If prices stay below this band, this could mean the start of a new bearish trend, especially if there's a lot of trading volume.

When the price of an asset touches or falls below the lower band, this could mean the asset is undervalued or that the selling pressure has gone too far, potentially leading to a reversal or pause in the downward trend.

Just as touching the upper band signals an increase in volatility, the price reaching the lower band indicates greater volatility in the context of a downward move. However, when the bands narrow after a period of wide fluctuation, there's decreased volatility, which might mean a significant price move as the price consolidates.

For investors employing mean reversion strategies or looking for bounce-back opportunities, the lower band can be used as a target for buying prospects. The rationale is that if the price has moved down to the lower band, it might rebound toward the middle band or higher, especially in a ranging market without a strong downtrend.

That said, if the price stays below the lower band, this signals a strong downtrend. Continual contact with the band or new lows below could indicate the bearish sentiment is strong and likely to continue. However, you should confirm this with other indicators to avoid false signals or traps.

A decisive move below the lower band can signify a breakdown or the start of a new bearish trend, especially if the volume is high and there are other bearish signals. Since further declines could occur, you can use this as a potential signal to sell or enter a short position.

What Widening Bands Mean

When the bands widen, this signals an increase in volatility because the standard deviation of the price increases. Thus, the price moves are more significant than in the recent past.

Economic announcements, earnings reports, geopolitical events, or sudden shifts in market sentiment can be behind these changes. Traders see increased volatility as an opportunity for substantial gains and a risk of greater losses.

The widening of the bands could signal the beginning of a substantial price trend. As volatility increases, the chance of a significant and sustained price move in one direction also increases. However, you should confirm this with other indicators or price patterns before proceeding.

When the bands widen after a period of contraction during a "squeeze," many consider this a sign that a breakout is about to occur. While the bands themselves do not indicate the direction of the breakout, investors can assess the potential direction by comparing the price's movement to the bands and other indicators.

The increased volatility signaled by widening Bollinger Bands might prompt investors to reassess their risk management strategies. They might cut their positions or diversify their holdings to manage the higher risk associated with greater price fluctuations.

What Tightening Bands Mean

A contraction of the bands suggests that the market is experiencing less volatility. Price movements are more contained, and there may be less trading volume or market interest in the short term. This reduced volatility period can be seen as a time of consolidation.

While tightening bands indicate less volatility, market analysts often consider this a precursor to major price moves or breakouts. Traders monitor squeezes closely since they suggest the market is building energy for a significant change. The longer the squeeze, the more potent the subsequent breakout is expected to be. This is based on the principle that periods of low volatility are frequently followed by periods of high volatility. However, this doesn't mean you'll know where the breakout will head.

During a tightening period, traders may adjust their risk management strategies, such as pulling in stop-loss orders to reflect lower volatility while preparing for a potential increase ahead.

The tightening of Bollinger Bands could also mean there's no consensus among market participants about the future direction of the price. This indecision can result in the price oscillating within a tighter range until new information arrives or the market forces a breakout.

How Reliable are Bollinger Bands?

The effectiveness of this tool depends on the asset involved, the settings used, and other factors:

• Asset involved: Each security has different volatility characteristics, affecting how well the tool helps with predictions. Assets that typically experience sudden shifts in volatility might not have the expected behavior within the bands.
• Parameters: The default setting for Bollinger Bands is a 20-period SMA with bands set at two standard deviations away. However, this may not be the best option for all trading scenarios or time frames. Adjusting the settings could improve their effectiveness but requires a good understanding of the markets and assets.
• Other indicators: Bollinger Bands are most effective when used with different tools and indicators. For instance, volume indicators and momentum oscillators like the relative strength index (RSI) or moving average convergence divergence (MACD) can give the needed context or help confirm signals from the Bollinger Bands.
• Outlier situations: The bands are based on a statistical measure of standard deviation, which assumes that asset price returns follow a normal distribution. However, financial markets are known for having fat tails that sometimes lead to unexpected moves beyond the bands.
  

The Bottom Line

Bollinger Bands is a versatile technical analysis tool that can provide greater clarity about market volatility and price trends. By framing price movements with upper and lower boundaries set at standard deviations around a central moving average, the indicator adapts to volatility in real-time, offering a visual representation of how prices are moving relative to historical norms. While it's valuable for highlighting potential reversals, breakouts, and trend strengths, Bollinger Bands is usually more effective when used with other indicators and methods.