Bollinger Band

Bollinger Band helps investors ascertain whether a particular stock is being oversold or overbought in the market.

A Bollinger band is a tool for technical analysis developed by American author and financial analyst John Bollinger. The tool is constituted by a set of trend lines and its purpose is to give investors an idea about when a particular stock is being oversold or overbought.

Bollinger Bands show two important indicators, like positive standard deviation and the negative standard deviation, from the simple moving average, which is typically a 20-day simple moving average (SMA), of the price of a particular security. The indicator can be adjusted as per individual preferences.

In short, Bollinger Band is composed of three lines namely, the SMA line or the middle band, the upper band and the lower band.

What does the Bollinger Band indicate?

Bollinger Band helps investors ascertain whether a particular stock is being oversold or overbought in the market. It is believed that the closer the price is to the upper band, the more overbought the stock is. Similarly, when the price is closer to the lower band, it could be an indication that the stock is being oversold.

Patterns in the Bollinger Bands

Breakout

Majority of the stock price movement occurs between the upper band and the lower band. When the price breaks the upper or the lower band to move beyond them, the Bollinger Band is said to be on a breakout. There is a common misconception among market participants that a breakout in a particular direction signals a buy or sell of the stock. In reality, the breakout is not a trading signal and it provides no clue to the extent and the direction of future movement.

Squeeze

When the upper band and the lower band come closer together compressing the middle band, the Bollinger Band is said to witness a squeeze. 

What does this squeeze indicate for the market participants? 

It shows a period of decreased stock volatility. More often than not, it is considered to be an indication of trading potential as it may signal increased volatility in future. As opposed to this, when the bands move far apart from the middle band, it is considered to be an indication of an exit potential and it may signal decreased volatility in future.

Calculation of the Bollinger Bands

The upper and lower bands in the Bollinger Bands are typically 2 standard deviations apart from the 20-day Simple Moving Average of the stock price (denoted by the middle band) in the respective direction.

• Hence, the first step in calculating the Bollinger Bands is to calculate the Simple Moving Average (SMA) of the security under consideration. Generally, a 20-day SMA is taken into account. The closing price for the first 20 days is taken as the first data point. This is to calculate the middle band.

• The next step is to calculate the standard deviation of the security price for the upper band. It typically measures as to how far numbers are from an average value. For this the moving average of the closing price of a security is taken into consideration and standard deviation is added. 

Formula= 20-day SMA + (2*20 Standard Deviation of closing price)

• To calculate the lower band, first compute the moving average of the close and subtract standard deviations from it. 

Formula= SMA 20-(2*20 Standard Deviation of closing price).

Complementary Indicators

A lot of technical indicators work best when paired with other indicators. As far as Bollinger Bands are concerned, they work the best with Relative Strength Indicator (RSI) and the BandWidth Indicator which measures the width of the bands with respect to the middle band.

Shortcomings of Bollinger Bands

The Bollinger Bands are computed using a simple moving average. Since a simple average gives equal weightage to older and recent data points, fresh and more relevant information may get mixed with outdated data points and become less relevant and less indicative.

The calculation elements (i.e., the 20-day SMA and the 2 standard deviations) are random and not based on some solid reasoning. It might not work accurately for every person in every situation.

It is hence recommended that market participants use the Bollinger Bands according to their own unique situations and should also pair them up with other relevant indicators to get a better picture.

In a Nutshell

Bollinger Bands can be a useful tool in the hands of a market participant who are looking to draw insight from the oversold or overbought position of a stock. The squeeze and breakout elements of the concept also help in indicating expected volatility in the market. However, to get more reliable inputs, it is recommended to use it with other relevant indicators.