Introduction
The amount of chart indicators out there within the stock market can be quite a lot. You have moving averages, Fibonacci retracement, Ichimoku Cloud, and more.
Each represents a different or unique method of interpreting data depending on your trading requirements. However, here, we will instead be directing our attention to one indicator in particular, and that is the BB, short for Bollinger Bands.
What is a Bollinger Band?
So what are Bollinger Bands exactly? Well, they’re a type of chart indicator used within technical analyses that have become rather popular in various trading markets, such as futures, currencies, and stocks.
The name comes from John Bollinger, who created them during the 1980s so that certain insights regarding volatility and price could be provided.
The Purpose of Bollinger Bands
In fact, the Bollinger Bands can be used for a variety of uses, like identifying oversold and overbought levels, as a tool for following trends, monitoring breakouts, measuring the volatility within the market, and discovering reversal signals.
Reversal signals can be particularly important considering that they mark the point when an asset is due for a “reversal,” as in it’s no longer going to go upward or downward but rather in the opposite direction.
The same is true for breakouts, which entail significant moves, usually beyond the known resistance or support levels.
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Components of Bollinger Bands
So, now that you know what a BB does, you might want to shift your attention to what it contains, or rather, its components, which boil down to three primary ones, i.e., the middle, upper, and lower bands, as we’ll look at below.
Middle Band (Simple Moving Average)
The middle band basically represents a certain period’s average price trend. It typically uses an SMA, or simple moving average, acting as a sort of baseline for determining the prevailing direction within the market. Prices below and above the band indicate downtrends and uptrends, respectively.
Traders usually assess the middle band, looking for any possible resistance or support levels. Should prices constantly bounce off that middle band, it might be hinting towards a potential strong trend within the market.
In addition to that, a middle band may be utilized in conjunction with various other technical indicators confirming trading signals. For instance, should the middle band align with a primary Fibonacci retracement level, it could likely be an indication of a possible price reversal point.
Upper Band
As for the upper band, it’s calculated by just adding some standard deviations to that middle band. It essentially represents the price range’s upper boundary, aiding with the identification of overbought circumstances within the market.
If prices cross above or just touch that upper band, it implies that the market might have been overextended and may reverse or correct itself.
Traders typically search other indicators for additional confirmation, like the RSI, short for Relative Strength Index, when prices touch that upper hand.
Once the RSI also indicates overbought conditions, it gives even more weight to the signal that a possible downturn could be imminent.
Lower Band
On the other hand, the lower band’s calculation involves subtracting some of those standard deviations from that middle band.
It’s basically the price range’s lower boundary and can aid with the identification of oversold instances or conditions. If prices touch or cross the lower band, it shows that selling pressure may be high with a possible price reversal being on the horizon.
However, like with the upper band, traders usually blend that lower band’s information with volume analysis to evaluate the strength of possible reversal.
This is because high selling pressure accompanied by the lower band’s breach could signal a more substantial price decline, particularly if trading volume is nowhere near the average.
How to Use Bollinger Bands in Trading
Now that you have a fair idea of what BB is supposed to mean in terms of stocks, we can move on to some of the different ways in which you can use them, namely the Bollinger Band Squeeze, the Bollinger Band Bounce, and the Bollinger Band Breakout.
Bollinger Band Squeeze
A Bollinger Band Squeeze happens when those bands become more narrow because of reduced volatility. And according to John Bollinger himself, periods where there’s little volatility are usually followed by those of higher volatility.
Hence, whenever there’s this contraction of volatility or band narrowing, you may potentially see a substantial decline or advance of some sort. So let’s say there’s a decline foreshadowed, then you may either be looking to buy the stock when the price is low or sell it before its value drops.
Bollinger Band Bounce
During specific instances, Bollinger bands tend to behave a bit like trampolines. Whenever objects hit trampolines, they tend to bounce back higher, as you may have seen. That’s the gist of it, really.
With this method, whenever prices touch that top band, they’ll settle back down towards the middle area. Likewise, if the prices reach or breach the lower band, they’ll bounce back up towards the middle of those bands. So if you know the price is due for a bounce on those bands, you may want to adjust your strategies accordingly.
Bollinger Band Breakout
The Bollinger Band Breakout strategy is basically when you enter a trade during moments when prices break through those lower or upper bands, signaling a possible continuation of present trends.
Traders may establish long positions during upper band breakouts or short positions during lower band breakouts. If you’re looking to manage your risk, you may conduct stop-loss orders just above or below those breakout points.
Advantages and Limitations of Bollinger Bands
Bollinger Bands, like any other trading indicator, has benefits and drawbacks, both of which should be considered if you are to make the most of it.
Benefits of Using Bollinger Bands
The first most obvious benefit is that it’s an effective tool for gauging volatility, and when volatility is gauged, there is a lot you can do with that—some short-term gains, for instance, or more.
Other than that, you may even know when a stock is overbought or oversold, enabling you to plan your strategies accordingly. All this means that you’re provided the means with which to be adaptable and more responsive to changes within the market, and within the stock market you can go quite far with that.
Limitations of Bollinger Bands
But benefits aside, there are some limitations you should be aware of. Firstly, know that it’s not necessarily a standalone indicator and that traders often combine it with other indicators for additional confirmation.
This brings us to our next point, which is the lag, and that it might take a while for the BB to identify a trend, and that’s plenty of time for missed opportunities that would have made all the difference.
Other than that, you should know that no indicator is full-proof and that, at times, you may have to deal with false signals.
Conclusion
Bollinger Bands are a widely used and versatile technical analysis tool that helps traders and investors identify market volatility and trends and generate various trading signals.
By gaining a comprehensive view of their components and applications, you can make more informed decisions, thereby enhancing their trading strategies.
But it’s vital to consider their limitations too and apply some additional indicators or techniques to make up for them.
What time frame works best with Bollinger Bands?
There’s really no single best timeframe that you can use with those Bollinger Bands. It all depends on the trading style you prefer. So, if you’re a day trader, for example, then you may want to use the BB on lower timeframes, such as the 5-minute or 15-minute timeframe. If you happen to prefer swing or position trading, then you may want to use the BB on the weekly or daily timeframe.
What does it mean when Bollinger Bands widen?
It means that there is higher volatility and that the potential to make some gains is there, but that you have to be even more cautious.
Can Bollinger Bands be used in trending markets?
If you see a bit of a wider gap between those bands, then it usually means that there is higher volatility and that the potential to make some gains is there, but that you have to be even more cautious.
What is the Bollinger Band squeeze?
Earlier we discussed the query regarding widening gaps. Well, what happens when those gaps narrow? That’s when you get the “squeeze,” which basically means that there is less volatility. Moreover, the very premise that the squeeze is reliant upon states that stocks constantly go through periods of higher volatility only to eventually be followed by lower volatility.
How do you interpret a Bollinger Band breakout?
There is one way you can go about interpreting it, and this basically involves identifying when the price of the stock in question has broken through either the lower or upper bands. This is when you know a breakout has occurred. However, the length of that will obviously vary. A lot of time, those breakouts are hardly long enough to warrant any meaningful interaction.
