Bollinger Bands are a technical analysis tool invented by John Bollinger. They consist of three lines: a simple moving average (typically 20-day) and two bands plotted above and below that average at two standard deviations. Together they form a price channel that contains approximately 95% of all price movement.
How Bollinger Bands Work
Bollinger Bands adjust dynamically to market volatility:
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When the market is calm, the bands contract toward the moving average.
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When the market becomes more volatile, the bands expand away from the moving average.
Interpreting Bollinger Bands
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Buy and Sell Signals: When a stock’s price moves below the lower band, it can be interpreted as a buy signal (indicating the stock may be “oversold”). Conversely, a price crossing above the upper band can suggest a sell signal (indicating the stock may be “overbought”).
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Squeezes and Breakouts: A “squeeze”—when the bands are very close together—often precedes a sharp price movement (“breakout”). The subsequent direction of the move must be confirmed with other technical indicators.
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Trends: Persistent price movement along one side of the moving average can indicate a sustained trend. If prices “ride” the upper band, the trend is bullish; repeated touches of the lower band suggest a bearish trend.
Notes and Pitfalls
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Sideways Markets: Bollinger Bands are especially useful in ranging markets, where prices oscillate between support and resistance. In strongly trending markets, prices can remain outside the bands for extended periods, which may produce misleading signals.
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Large Price Moves: While a band squeeze can warn of an impending big move, it does not indicate direction. Other indicators should be used to anticipate which way prices are likely to move.
Practical Application
Bollinger Bands should be one tool among many, not used in isolation. Their effectiveness increases when combined with other indicators such as the RSI (Relative Strength Index) or MACD (Moving Average Convergence Divergence). Remember that no indicator is infallible; every signal should be confirmed with additional analysis.
Summary
Bollinger Bands offer unique insight into market volatility and potential inflection points. By understanding and applying this tool correctly, investors can better interpret market behavior and make more informed decisions. However, true investment success requires a balanced approach and the use of multiple technical analysis tools.
