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 develop 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.
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.
The Topmost Rules For Using Bollinger Bands
- Bollinger bands define the price level. Low price at the lower band and high price at the upper.
- The bands considered as a comparable 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 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 the average is shortened, the number of SD need to be reduced. 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. This is caused by the large price change. The EA generally use in both the center band and in the calculation of SD.
- Based on the use of the standard deviation calculation, 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.
- BB can be used 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.
Categories: Trading Strategy