Bollinger bands, in stock markets, are the technical analysis tools invented by John Bollinger in 1980. Stock traders use Bollinger bands to determine the entry and exit price while trading.
While you might have gained knowledge about several indicators to analyze exit and entry points, the Bollinger bands focus on price volatility to help you find the points. Thus, it is a crucial tool for stock market traders.
Bollinger bands are a famous technical analysis tool used to spot three different lines drawn on the chart, with one below and another above the security price. Bollinger bands are a lagging indicator, and it is based on a simple moving average.
The bands show the levels of highs and lows of the price. It helps traders to estimate when the price reaches its relative strength and when it is paused for a particular duration.
Bollinger bands use helps to analyze the upper and lower bands to determine the price targets. However, these can also be used with support, resistance, moving averages, MACD, stochastics, and RSI indicators.
To understand Bollinger bands in stock market, you must know that it is somewhat like moving averages, but the results differ. The calculation considers standard deviation levels in Bollinger bands to draw the lower and upper lines. On the other hand, moving averages draw their conclusion through a fixed percentage.
To calculate the Bollinger bands value, the variables taken are:
Period – ‘N’
Standard Deviation – ‘S’
Three Bollinger Bands or Lines
The three Bollinger lines consist of three more settings that include the following three:
Moving Average Line or Middle Band
Upper Band or Moving average shifting above
Lower Band or Moving average shifting below
Traders use various settings to analyze their entry and exit points with Bollinger bands. The most popular setting in a variable for moving average is 20-day simple with a standard deviation of 2. However, some traders use exponential moving averages too.
Bollinger bands are used in charts to determine the strong points of an asset with its rising and reversing cause. Stock traders can analyze if the security is losing its strength or gaining strength to rise in price.
The upper band of Bollinger bands is used to determine the uptrends movement as it confirms the probability of its rising. If an uptrend is strong, the price will usually reach the upper band.
The indication the traders should receive is that it is the best time to exploit the opportunity of buying in the dips. As it keeps touching the upper band, it indicates a lot of strength, and the stock is pushing its worth to reach a newer price.
Many technical traders use strong uptrends to develop profits in their trade to save themselves from reversals. First, however, the traders must keep watching the security and judging its movement. When the asset, at a point, fails to reach a new peak, it is ascertained that the asset is incurring losses through a potential reversal trend.
Thus, technical traders should regularly monitor the security with Bollinger bands’ upper band to observe the strength and weakness of the stock.
Bollinger bands trading strategy can help in determining the downtrend with the help of the lower band formed on the chart. In addition, it is used by traders to understand how fast the security price can fall to reverse in the uptrend movement.
A security with a downtrend movement shows that there is a high selling activity going on by the sellers. Therefore, the price will keep moving and touching the lower band of security. However, traders need to note that if the price repeatedly meets the lower band without forming a bearish movement, it loses momentum.
Technical traders generally avoid trading during downtrends as the downward movement can be short or long, making it uncertain for the traders. Therefore, investors and traders should identify the downtrends concerning the lower Bollinger band to identify any sign of reversal or avoid entering a long-term trade.
Bollinger bands use M-Pattern and W-Pattern trading to identify the top and bottom formation of the security. For example, John Bollinger has used M-Pattern and W-Pattern to identify the movement in securities.
Bollinger bands use W-Pattern to identify the formation of W-shaped bottoms that indicates the second low formed lower than the previous low but holds below the lower band. As per the figure, you can observe that W-shape is formed to indicate that the price is likely to rise with double bottom.
Further, the M-Pattern Bollinger band is used to identify the top formation or double tops. You can relate it with the double top pattern formed with an M shape. It occurs when the price moves near or around the upper band when it pulls it back to sustain over the middle band, although the price is unlikely to close above the upper band.
M-Pattern forms to create a new price high but then move towards the low segment in a pullback that suggests a downtrend.
In mathematical calculation, the upper band is calculated by adding the middle band and twice the daily standard deviation amount. In contrast, the lower band is calculated by subtracting the middle band by two times of daily standard deviation amount.
Bollinger bands are helpful technical analysis tools for traders to determine a trend using an upper band and lower band; however certain limitations that follow the Bollinger bands are:
The standard setting of Bollinger bands is popular among traders, but it is not appropriate for every trader. Traders must depend on their practice and analysis to generate the setting that works for them.
The effectiveness of using Bollinger bands depends on one market to another. It might work great during currency chart analysis and with equity chart analysis variances. It depends upon the setting on uses to trade in the market over time.
Price predictions cannot be made using only Bollinger bands, as traders should use all the systems of trading rules and requirements with Bollinger bands.
As the price of a security will be volatile, the change in Bollinger band’s movements will change as well. Thus, it reacts to the change in uptrend and downtrend movement in security.
Lastly, Bollinger bands are primarily reactive and not predictive, which means that traders use the Bollinger bands to analyze the price reaction and change, but not predict the prices.
The blog concludes that Bollinger bands use the upper and lower bands where the price is high and low, respectively. The tool is used to develop entry and exit points in the security by assessing the ongoing reaction of the price.
The information presented in the blog post is mandatory as it will help you develop a base for understanding a deeper analysis of Bollinger bands in our next blogs. Keep in mind the limitations of Bollinger bands before opting for the tool while trading.
John Bollinger invented the tools of Bollinger bands during the 1980s.
A simple moving average is the foundation of Bollinger bands.
The price targets are determined using upper and lower bands of Bollinger bands.
Bollinger bands consider the calculation using standard deviation.
The most popular setting of the Bollinger band is 20-day SMA and 2 Standard deviations.
The upper band of Bollinger determines the rising form of the price
The lower band of Bollinger determines the falling formation of the price
If the stock price keeps touching the upper band, it shows strength.
If the stock price keeps touching the lower band, it shows weakness in the stock.
M-pattern analyses the downward movement after reaching a high price
W-pattern analysis of the upward movement after rebounding from a lower price.