Bollinger Bands: Strategy & Formula in Trading (2024)

Bollinger Bands are a technical anaylsis indicator that can be used to determine whether an instrument is overbought or oversold within the financial markets, and it can also be used to assess volatility. Bollinger Bands consist of three lines on a trading chart​. The middle line of the indicator is the simple moving average (SMA) of the instrument's price, which is the average of the price over a certain length of time. This is generally set to a 20-day period. The upper band is the SMA plus two standard deviations​. The lower band is the SMA minus two standard deviations.

Either side of the SMA is a Bollinger Band. Bollinger Bands look like an envelope around the price of the instrument. The widths of the bands are determined by the standard deviation. Standard deviation refers to the volatility of the instrument's price movements. This is generally set to 2.0.

The period is the number of intervals that are included in the Bollinger Band calculation. A setting of (20, 2) means that the period and standard deviation are set to 20 and 2.0, respectively. For Bollinger Bands with a setting of 20, 2, the bands are calculated according to the following formulas:

Upper band = 20-day SMA + (20-day standard deviation x 2)

Lower band = 20-day SMA – (20-day standard deviation x 2)

Bollinger Bands can be used on all chart timeframes​ including weekly, daily, or five-minute charts. The settings can be adjusted to suit different trading styles. When the instrument's price moves towards the upper band, this is a signal that it is overbought. As a general rule, traders look to sell when they believe that an instrument is overbought. When the instrument's price moves towards the lower band, this is a signal that it's oversold. Generally, traders look to buy securities that are oversold.

As a trading indicator, Bollinger Bands are not perfect. They don’t produce reliable signals all the time. Consequently, they are best used alongside other similar technical analysis indicators to provide more accurate trading signals. Some of these complimentary technical analysis tools that can be found on our Next Generation platform​ include:

Moving averages are a popular trading tool. These are used by traders to determine trend direction. A moving average shows the average price of a security over a certain period of time. The basic rule of moving averages is that if a security's price is above the moving average, the trend is up. If the price is below the moving average, the trend is down.

Moving averages can be set to different timeframes, depending on the trader’s strategy. There are also different types of moving averages. These include a simple moving average​ (SMA) and exponential moving average​ (EMA).

The average true range (ATR)​​ is a technical indicator that measures volatility. Originally designed for analysing commodities, it can be applied to other instruments such as indices and stocks.

A security experiencing a high level of volatility will have a higher ATR. A security experiencing low volatility will have a low ATR. Traders use ATR to identify entry and exit points. It can be a useful tool when combined with other trading indicators.

There are a variety of trading strategies​ that traders use with Bollinger Bands. Some of the more popular trading strategies that can help traders in bear or bull markets include:

Riding the bands

Many traders mistakenly believe that because a security's price has touched the upper band they should go short, or vice versa. However, such price movements should not be viewed as signals to buy or sell. Price penetration of the bands alone is not an indicator to enter a trade. This is because during a strong uptrend or downtrend, prices can often stick within the bands.

Bollinger Band squeeze

This strategy uses an indicator named 'band width'. Band width is calculated with the following formula:

Band width = (upper Bollinger band value – lower Bollinger band value) / middle Bollinger band value

The idea behind this indicator is that when it hits a six-month low, traders can expect volatility to increase. At this point in time, a squeeze is triggered and the instrument's price may move significantly.

Bollinger Bands can be set to many different timeframes and adjusted to different trading strategies. For example, the bands can track movements on hourly, daily, weekly and monthly charts. A trader looking at long-term moves in an instrument's price may prefer to set up Bollinger Bands on a monthly chart.

​In contrast, a short-term day trader​​ may prefer to set up Bollinger Bands on a five-minute chart. In reality, there is no single best timeframe for Bollinger Bands. The timeframe used will depend on the strategy of the trader.

In a double bottom, an instrument's price will move sharply lower, with substantial volume, and close outside the lower Bollinger Band. It will then rebound higher briefly towards the middle band. Lastly, it will fall lower again, this time on lower volume, and close just inside the lower band.

This pattern indicates that downward pressure has subsided. There is a shift from sellers to buyers. Often, the next price movement is a strong move upwards off the second low. Traders may look to go long, targeting the middle or upper band.

Bollinger Bands are an effective technical analysis indicator, however, they do have limitations. Bollinger Bands are based on an instrument's simple moving average, which uses past data points. As a result, the bands will always react to price moves, and not forecast them. In other words, Bollinger Bands are reactive, not predictive, and are often referred to as a lagging indicator​, rather than leading.

Bollinger Bands can also be prone to providing false signals. For example, a false breakout occurs when an instrument's price passes through the trade entry point. It signals a trade, but then moves back in the other direction. This results in a losing trade.

When trading with Bollinger Bands, traders should understand that standard settings will not suit all strategies. Long-term position traders may prefer to use a greater number of periods and a higher standard deviation, whereas daytraders and swing traders may prefer to use a lower number of periods and lower standard deviation. For this reason, the Bollinger Bands indicator is best used in conjunction with other indicators and tools as part of an overall trading strategy.

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