How to Use Bollinger Bands
You can use Bollinger Bands® to identify sharp, short-term price movements as well as potential entry and exit points.
Many traders find Bollinger Bands® to be an invaluable technical analysis tool. Invented in 1983 by John Bollinger, they help traders evaluate price action and volatility.
Let’s begin by discussing what Bollinger Bands are, and what they look like. It is comprised of a middle band which is a moving average, as well as an upper and lower band set away from the moving average at a certain number of standard deviations for incorporating volatility. By gauging where the stock sits in relation to the bands, traders can decide if its price is high or low compared to others. Additionally, wider bands signify greater volatility than narrower ones.
Bollinger Bands generally use a 20-period moving average, where the “period” could be 5 minutes, an hour, or a day. In default, the upper and lower bands are two standard deviations above and below the moving average. However, traders may customize the number of periods and deviations in the moving average.
Bollinger Bands: Using them
In order to understand how to use Bollinger Bands, one thing to keep in mind: If the price touches the upper band, it doesn’t necessarily mean that you should sell. Likewise, when it touches the lower band, it doesn’t necessarily mean you should buy. In fact, take it from John Bollinger himself who said, “There is absolutely nothing about a tag of a band that is in and of itself a signal.”
When a price is in a strong down- or uptrend, it can “walk the band,” or touch or break the lower or upper band repeatedly. In other words, you may prefer to wait and look for chart patterns like the “double bottom,” the “classic M top,” or the “three pushes to high” formation rather than taking action when the price touches either band. In more detail, let’s look at these chart patterns:
The double bottom
It occurs when there is a fall in price followed by a rise, followed by another fall near the previous low, and finally another rise.
Look for a price that touches the lower band and wait for the next low to occur to identify a double bottom. A price that reacts and rises close to the middle band, followed by a second low inside the lower band, suggests that the price is positioned for an upward move—a good time for traders to invest.
The Bollinger Band may indicate that the stock is preparing for an uptrend, even if the second low is lower than the first low. But without the Bollinger Band, the stock may appear to be trending down on the second low.
As a result of this scenario, you may notice that volume is also decreasing. This may be a reliable indicator of decreasing momentum.
With the first high above the upper band, the second high at it, and the third high beneath it, the “three pushes to high” formation is complete.
Trends beginning or ending
An end to a strong trend can also be indicated by Bollinger Bands. A strong trend, especially one that breaks out of a trading range, will lead to an increase in volatility, which will cause the bands to initially move apart. Thus, if the lower band moves downward in the opposite direction of a strong uptrend, it can be a sign that the move higher may be over, at least for a while, if the lower band is turned back up.
In addition to Bollinger Bands, volatility tends to be mean-reverting: Periods of low volatility are usually followed by periods of high volatility.
In a squeeze, bands are narrow, indicating low volatility. A simple way to spot a squeeze is to identify when the bands are the narrowest they have been for the last six months. However, since volatility is mean-reverting, the bands will probably expand, signaling a potential explosive move.
Bollinger Bands show a squeeze in Figure 5, indicating more volatility ahead.
If you’re looking to benefit from a squeeze trade, think about buying above the upper band. Set a stop order below the low of the breakout formation or under the lower band. If you’d rather short sell, make an entry point beneath the lower band and put a stop over either the high of the breakout pattern or over the opposite band. Adjust your stops as appropriate and to capture greater profits, consider using either a fixed dollar amount trailing stop or a fixed percentage. Alternatively, use parabolic SAR indicator to aid your trailing effort. Lastly, when trading long exit if it touches the lower band and vice versa for short selling.