Bollinger Bands is similar to price envelopes like ATR Bands. Though the difference of Bollinger with many other bands is that Bollinger bands indicator is plotted at specific standard deviation levels. The default standard deviation levels are 2. There is also a mid-band besides the upper and lower band. If st.dev. is 2, then the upper band is at +2 st.dev. and the lower band is at -2 st.dev. and middle band at zero. The Bollinger band is invented by John Bollinger and is characterised by the following.
Bollinger Bands is one of the most widely used indicators in technical analysis. Though it includes various rules, the application procedure is quite simple. Before stepping forward let’s have some word about the creator of Bollinger Bands. The famous financial analyst and a contributor to the field of technical analysis John Bollinger developed Bollinger Bands in 1980. The statistical chart helps to indicates the price and volatility of a security by using formulaic methods of John Bollinger.
Bollinger Bands Definition
The functions of this particular technical tool spread in different dimensions. First, let’s talk about what it looks like. It consists of three lines, a centre line and two outer, overall looks like a band. There is a tendency of the price level to come toward the centre line. The outer lines generally work as a support and resistance level. When the market is less volatile, the outer lines come towards the centre line. The reverse happens in case of a more volatile market. There is another important technique of the bands. The price level is low at the lower band and high at the higher band. The middle line mainly works as a base of the other two lines.
Bollinger Bands Indicator Formula
To compute the particular technique you need to know Standard Deviation Calculation (to measure volatility) first.
- Upper Band= 20-day SMA + (20-day Standard Deviation of price x 2)
- Middle Band = 20-day SMA (Simple Moving Average)
- Lower Band = 20-day SMA – (20-day Standard Deviation of price x 2)
The above script is GLENMARK’s 1-hour script, taken from Zerodha Kite. However, it shows the price is at a higher level in the upper band and low in the lower bands. The large gap between the upper and lower bands indicates more volatility in the market.
Few Thumb Rules of Trading with Bollinger Bands Indicator
- Sharp price changes tend to occur after the bands tighten greatly due to a decrease in volatility.
- If prices move outside the bands, we can expect that the price will continue in that direction.
- If bottoms and tops are made outside the bands, followed by bottoms and tops inside the bands, price reversal is imminent.
- After a reversal, trend originates at one band and tend to finish at another band. We can use these observations to project price targets.
These bands are very popular among analysts, traders and investors due to their effectiveness. Kite charts plot this indicator for traders.
How to set up Bollinger Bands indicator in Zerodha Kite?
- Go to MarketWatch.
- Choose the stock you are going to trade.
- Right click on the stock and select chart from graphic icons.
- Chart window of the stock opens.
- Go to studies. Select studies.
- Go to Bollinger bands and click on it.
- A small window opens with default parameters of the indicator.
- Once the parameters are selected, the Done command is chosen, the parameters window goes off the screen and the indicator is plotted on stocks price.
- By default, Bollinger bands indicator uses 20-day simple moving average and 2 standard deviations which we can change as per our own requirement.
Bollinger Band in intraday –
- The indicator works well all the time frames.
- The picture above shows the State Bank of India (SBIN) stock price movement with respect to the Bollinger Band.
- The chart shows for 1 min. timeframe.
- The strategy shows the price trend. Understanding price trend from this indicator is important before creating a position.
- In 1 minute chart, traders may find many whipsaws which they can eliminate if they use longer time frames and they use these bands with a combination of other indicators.
The indicator works very well and is widely used in creating bullish or bearish positions. In general, when the Bollinger Bands indicator touches the lower band it denotes that the price reaches the oversold zone and can bounce back and similarly when the price touches the upper band it denotes that the price has reached the overbought zone and can correct from here.
The Topmost Rules For Using Bollinger Bands
The developer John Bollinger has set 22 rules to trade the Bollinger Bands Indicator. We are listing these rules below:
- Bollinger bands define the price level. Low price at the lower band and high price at the upper.
- The bands considered as a comparison tool between price and indicator action to point out the buy-sell decision.
- Momentum, volume, sentiment, open interest, inter-market data, etc are the important factors in this indicator.
- In the case of more than one indicator, the indicators should not be directly related to one another.
- In order to recognize price patterns such as “M” tops, “W” bottoms, momentum shifts, etc, BB can be used.
- Tags in the bands are not considered as signals, like a tag of the upper band is not sell signal while tag in the lower band is not a buy signal.
- In a trending market, volatility comes often. Hence, price walks up to the upper band while down the lower band.
- If price closes outside the BB, it doesn’t mean the trend reversal is going to appear soon. It means the current trend will continue.
- For MA (Moving Average) and SD (Standard Deviation) calculation, set the default parameters at 20 periods.
- The centerline of BB should not be the best one for crossover.
- With the increase in average, the number of SD needs to be increased. From 2 to 20 periods to 2.1 to 50 periods. On the other hand, when we shorten the average, we also need to reduce the number of SD. From 2 at 20 to 1.9 at 10 periods.
- Classical BB is depended upon an SMA (Simple Moving Average). The reason is SMA is used to calculate SD (Standard Deviation).
- EBB (Exponential Bollinger Bands) avoids sudden changes in the width of the bands. A large price change causes this. The EA generally use in both the center band and in the calculation of SD.
- Based on the use of the standard deviation calculation, it makes no statistical assumptions.
- By using an adaption of the formula for Stochastic, the position within the bands is calculated.
- In order to identify divergence, pattern, trends, BB is an important tool.
- By eliminating fixed thresholds in the process, indicators can be normalized.
- To find out the width of BB, you need to follow BandWidth. By using the center band, the raw width is normalized.
- In order to identify the changing trend, bandwidth plays a significant role.
- In equity, indices, foreign exchange, future, options, commodity and bonds, BB can be used.
- We can use BB in any time frame of bars, 5 min, one hour, daily, weekly, etc.
- It helps to identify the odd one and don’t provide continuous advice.
As 90% of price action generally happens inside the bands, the Bollinger Bands indicator works very well in the rangebound markets. On the other hand, it also helps to identify the market trend as well. 2 consecutive closes outside the bands can denote that the market can trend to that direction for some time now and that can denote the start of a strong trend. It’s better to use this technical indicator in combination with other indicators.
Indrajit is a professional blogger and trading system developer. Amibroker expert, WordPress expert, SEO expert and stock market analyst.Trading since 2002, he has started the journey of StockManiacs.net on 2008. He follows Indian and world stock markets closely.