Bollinger Bands are a technical indicator developed by John Bollinger. They represent the volatility in prices of a security in chart form. They are very useful to technical analysts or a trader. The later use Bollinger Bands trading strategy to predict future price moves in a security or stock.
Bollinger Bands consist of 3 components –
– An Upper Band
– A Lower Band
– A Middle Simple Moving Average graph line
Talking about Bollinger Bands settings , by default, the simple moving average (SMA) Period is usually 20 days. However, some other charting software may have the setup with 14 days or 21 days also. You may adjust that according to your requirement, anyways.
The Upper and Lower Bands are placed 2 Standard Deviation (SD) above and below the SMA. SD represents the dispersion of values from the mean. As per statistical rules, 2 SD covers 95% of data. So 95% of data is covered between both of these Bands.
Interpreting The Bollinger Bands
If you see a technical chart for any security with Bollinger Bands drawn on it, You would find that the prices keep oscillating between two extremes. These are the upper and lower bands.
After touching the upper band, the prices start falling and after touching the lower band, the prices start rising.
These extremes of upper and lower bands also reflect the overbought and oversold market situations. Prices of a security at upper band are in overbought situation.
From overbought zones, they are expected to correct or fall in near future. Similarly, at lower band, the security is in oversold zone and likely to see buying at lower levels in future.
We talked above that Bollinger Bands show the volatility in prices. When the prices show high volatility, the Bands become wider ; when there is low volatility, the Bands come closer and become narrow.
Narrow Bollinger Bands are indicative of impending big move in security prices in coming days. This is also indicative of a trend reversal in security prices. So volatility is expected to rise. Likewise, for wider Bollinger Bands, the high volatility is expected to calm down.
This property of Bollinger Bands may be useful to Options Traders. They may choose to sell Options when Bollinger Bands are wider, expecting volatility to come down. Consequently the Option Premiums also fall with volatility. They would buy back those Options at lower prices to earn profits.
On the other hand, when Bollinger Bands are narrow, they may choose to buy Options. With low volatility, the Option Premiums are low and hence options are less costly to buy.
When volatility rises, along with rise in underlying price, the increase in Premiums is comparatively more. Hence Options are more profitable to sell then.
Bollinger Bands Strategy : Stop Loss and Target Price
We see that prices keep touching upper and lower bands of Bollinger Bands. Prices have the tendency to stay between those Bands. Even if prices shoot above or below those Bands on any trading day, they try to come back again inside the Bands.
Traders usually use this feature of Bollinger Bands strategy to take trading decisions. When the prices touch the upper band and the band shows downward move, it is time to go short or sell the security.
Target Price for the short position is price corresponding to the lower band. Short position is closed when the prices hit the lower band. Some traders like to go short when the price fall below the Simple Moving Average Line and take profits when price moves to lower band.
On the other hand, when the prices are trading at lower band and the later shows a turn towards upside, the traders may take the opportunity to go long or buy the shares.
Your Target Price is the upper band. The position is closed when prices hit upper band. Some traders take long position only when the prices has moved above the Simple Moving Average Line.
It is worth mentioning here that like all other technical indicators, the Bollinger Bands also should be used in conjunction with other indicators showing overbought and oversold conditions like Stochastic and Relative Strength Index (RSI).