Bollinger Bands is a technical analysis tool developed by John Bollinger that is used to visualize price volatility and identify potential overbought or oversold conditions for a stock. They consist of three lines: a middle band (typically a 20-day simple moving average, or SMA), an upper band (SMA plus two standard deviations), and a lower band (SMA minus two standard deviations).
How They Work
The bands widen or narrow based on price volatility. When the price approaches the upper band, it suggests the stock might be overbought; conversely, approaching the lower band suggests it could be oversold. The distance between the bands reflects the volatility of the stock.
Key Patterns
- Breakout: When the price moves outside the bands, it’s called a breakout. This doesn’t necessarily signal a buy or sell, but rather increased volatility and potential for a significant price move.
- Squeeze: When the bands narrow, it indicates low volatility, often preceding a period of increased volatility and potential trading opportunities.
Calculation
- Calculate the 20-day Simple Moving Average (SMA) of the stock price (middle band).
- Calculate the standard deviation of the closing price.
- Upper Band: 20-day SMA + (2 * Standard Deviation)
- Lower Band: 20-day SMA – (2 * Standard Deviation)
Benefits:
- Visualizes Volatility: Easily see how much the stock price fluctuates.
- Identifies Potential Overbought/Oversold: Helps pinpoint when a stock may be due for a reversal.
- Potential Trading Signals: Breakouts and squeezes can signal upcoming price movements.
Shortcomings
- Lagging Indicator: Based on moving averages, so it can be slow to react to rapid price changes.
- Not Always Accurate: Can generate false signals, especially in trending markets.
- Requires Confirmation: Best used in conjunction with other technical indicators like the Relative Strength Index (RSI).
Conclusion
Bollinger Bands are a valuable tool for traders and investors to assess volatility and identify potential turning points in a stock’s price. However, they should not be used alone and should be combined with other technical analysis methods and risk management strategies.
