How to Use Bollinger Bands to Gauge Trends

Reviewed by Gordon ScottFact checked by Vikki VelasquezReviewed by Gordon ScottFact checked by Vikki Velasquez

Bollinger Bands® are a type of chart indicator for technical analysis and have become widely used by traders in many markets, including stocks, futures, and currencies. Created by John Bollinger in the 1980s, the bands offer unique insights into price and volatility. In fact, there are a number of uses for Bollinger Bands®, such as determining overbought and oversold levels, as a trend following tool, and for monitoring for breakouts.

Key Takeaways

• Bollinger Bands® are a trading tool used to determine entry and exit points for a trade.
• The bands are often used to determine overbought and oversold conditions.
• Using only the bands to trade is a risky strategy since the indicator focuses on price and volatility, while ignoring a lot of other relevant information.
• Bollinger Bands® are a rather simple trading tool, and are incredibly popular with both professional and at-home traders.

Calculation of Bollinger Bands

Bollinger Bands® are composed of three lines. One of the more common calculations uses a 20-day simple moving average (SMA) for the middle band. The upper band is calculated by taking the middle band and adding twice the daily standard deviation to that amount. The lower band is calculated by taking the middle band minus two times the daily standard deviation.

The Bollinger Band® formula consists of the following:

​BOLU=MA(TP,n)+m∗σ[TP,n]BOLD=MA(TP,n)−m∗σ[TP,n]where:BOLU=Upper Bollinger BandBOLD=Lower Bollinger BandMA=Moving averageTP (typical price)=(High+Low+Close)÷3n=Number of days in smoothing periodm=Number of standard deviationsσ[TP,n]=Standard Deviation over last n periods of TP​

Overbought and Oversold Strategy

A common approach when using Bollinger Bands® is to identify overbought or oversold market conditions. When the price of the asset breaks below the lower band of the Bollinger Bands®, prices have perhaps fallen too much and are due to bounce. On the other hand, when price breaks above the upper band, the market is perhaps overbought and due for a pullback.

Using the bands as overbought/oversold indicators relies on the concept of mean reversion of the price. Mean reversion assumes that, if the price deviates substantially from the mean or average, it eventually reverts back to the mean price.

Important

Bollinger Bands® identify asset prices that have deviated from the mean.

In range-bound markets, mean reversion strategies can work well, as prices travel between the two bands like a bouncing ball. However, Bollinger Bands® don’t always give accurate buy and sell signals. During a strong trend, for example, the trader runs the risk of placing trades on the wrong side of the move because the indicator can flash overbought or oversold signals too soon.

To help remedy this, a trader can look at the overall direction of price and then only take trade signals that align the trader with the trend. For example, if the trend is down, only take short positions when the upper band is tagged. The lower band can still be used as an exit if desired, but a new long position is not opened since that would mean going against the trend. 

Create Multiple Bands for Greater Insight

As John Bollinger acknowledged, “tags of the bands are just that, tags not signals.” A tag (or touch) of the upper Bollinger Band® is not in and of itself a sell signal. A tag of the lower Bollinger Band® is not in and of itself a buy signal. Price often can and does “walk the band.” In those markets, traders who continuously try to “sell the top” or “buy the bottom” are faced with an excruciating series of stop-outs, or even worse, ever-mounting losses as price moves further and further away from the original entry.

Note

Perhaps a more useful way to trade with Bollinger Bands® is to use them to gauge trends.

At the core, Bollinger Bands® measure deviation, which is why the indicator can be very helpful in diagnosing trend. By generating two sets of Bollinger Bands®, one set using the parameter of “one standard deviation” and the other using the typical setting of “two standard deviations,” we can look at price in a whole new way. We will call this Bollinger Band® “bands.”

In the chart below, for example, we see that whenever price holds between the upper Bollinger Bands® +1 SD and +2 SD away from mean, the trend is up; therefore, we can define that channel as the “buy zone.” Conversely, if price channels within Bollinger Bands® –1 SD and –2 SD, it is in the “sell zone.” Finally, if price meanders between +1 SD band and –1 SD band, it is essentially in a neutral state, and we can say that it’s in uncharted territory.

Bollinger Bands® adapt dynamically to price expanding and contracting as volatility increases and decreases. Therefore, the bands naturally widen and narrow in sync with price action, creating a very accurate trending envelope.

A Tool for Trend Traders and Faders

Having established the basic rules for Bollinger Band® “bands,” we can now demonstrate how this technical tool can be used by both trend traders who seek to exploit momentum and fade-traders who like to profit from trend exhaustion or reversals. Returning to the chart above, we can see how trend traders would position long once price entered the “buy zone.” They would then be able to stay in the trade as the Bollinger Band® “bands” encapsulate most of the price action of the move higher.

As for an exit point, the answer is different for each individual trader, but one reasonable possibility would be to close a long trade if the candle on the candlestick charts turn red and more than 75% of its body were below the “buy zone.” Using the 75% rule, at that point, price clearly falls out of trend, but why insist that the candle be red? The reason for the second condition is to prevent the trend trader from being “wiggled out” of a trend by a quick move to the downside that snaps back to the “buy zone” at the end of the trading period.

Note how, in the following chart, the trader is able to stay with the move for most of the uptrend, exiting only when price starts to consolidate at the top of the new range.

Bollinger Band® “bands” can also be a valuable tool for traders who like to exploit trend exhaustion by helping to identify the turn in price. Note, however, that counter-trend trading requires far larger margins of error, as trends will often make several attempts at continuation before reversing.

In the chart below, we see that a fade-trader using Bollinger Band® “bands” will be able to quickly diagnose the first hint of trend weakness. Having seen prices fall out of the trend channel, the fader may decide to make classic use of Bollinger Bands® by shorting the next tag of the upper Bollinger Band®.

As for the stop-loss points, putting the stop just above the swing high will practically assure the trader is stopped out, as the price will often make many forays at the recent top as buyers try to extend the trend. Instead, it is sometimes wise to measure the width of the “no man’s land” area (distance between +1 and –1 SD) and add it to the upper band. By using the volatility of the market to help set a stop-loss level, the trader avoids getting stopped out and is able to remain in the short trade once the price starts declining.

Bollinger Bands Squeeze Strategy

Another strategy to use with Bollinger Bands® is called a squeeze strategy. A squeeze occurs when the price has been moving aggressively then starts moving sideways in a tight consolidation. 

A trader can visually identify when the price of an asset is consolidating because the upper and lower bands get closer together. This means the volatility of the asset has decreased. After a period of consolidation, the price often makes a larger move in either direction, ideally on high volume. Expanding volume on a breakout is a sign that traders are voting with their money that the price will continue to move in the breakout direction.

When the price breaks through the upper or lower band, the trader buys or sells the asset, respectively. A stop-loss order is traditionally placed outside the consolidation on the opposite side of the breakout.

Bollinger vs. Keltner

Bollinger Bands® and Keltner Channels are different, but similar, indicators. Here is a brief look at the differences, so you can decide which one you like better. 

Bollinger Bands® use standard deviation of the underlying asset, while Keltner Channels use the average true range (ATR), which is a measure of volatility based on the range of trading in the security. Aside from how the bands/channels are created, the interpretation of these indicators is generally the same.

Important

One technical indicator is not better than the other; it is a personal choice based on which works best for the strategies being employed.

Since Keltner Channels use average true range rather than standard deviation, it is common to see more buy and sell signals generated in Keltner Channels than when using Bollinger Bands®.

The Bottom Line

There are multiple uses for Bollinger Bands®, including using them for overbought and oversold trade signals. Traders can also add multiple bands, which helps highlight the strength of price moves. Another way to use the bands is to look for volatility contractions. These contractions are typically followed by significant price breakouts, ideally on large volume. Bollinger Bands® should not be confused with Keltner Channels. While the two indicators are similar, they are not exactly alike.

Read the original article on Investopedia.