Bollinger Bands Explained

Bollinger Bands measure volatility and identify potential overbought/oversold conditions. They adapt to market conditions, widening during volatile periods and narrowing during calm periods. [DEFINITION] Bollinger Bands: A volatility indicator consisting of three lines—a middle simple moving average (typically 20-day) and upper/lower bands set at 2 standard deviations above and below the middle line. ### Band Components **Middle Band:** 20-day SMA (or your chosen period) **Upper Band:** Middle Band + (2 × standard deviation) **Lower Band:** Middle Band - (2 × standard deviation) [KEY] Statistically, about 95% of price action should occur within the bands (2 standard deviations). When price exceeds the bands, something notable is happening. ### Interpreting Bollinger Bands **Price touching upper band:** - Stock is relatively high - Potentially overbought - But can "walk the band" in strong trends **Price touching lower band:** - Stock is relatively low - Potentially oversold - But can "walk the band" in strong downtrends [TIP] Don't automatically sell when price hits the upper band or buy when it hits the lower band. In trends, price can stay at the bands for extended periods. ### The Bollinger Squeeze [DEFINITION] Squeeze: When bands narrow significantly, indicating low volatility that often precedes a large move. **How to trade the squeeze:** 1. Identify narrowing bands (visual or use bandwidth indicator) 2. Wait for breakout from the tight range 3. Trade in direction of breakout 4. Expect above-average move after low volatility [EXAMPLE] After weeks of low volatility, Apple's Bollinger Bands squeeze to their narrowest point in 6 months. Suddenly, price breaks above the upper band with volume. This could be the start of a significant rally. ### Bollinger Band Strategies **Mean Reversion Strategy:** - Buy at lower band in uptrend - Sell at upper band in downtrend - Works best in ranging markets **Breakout Strategy:** - Buy when price breaks above upper band after squeeze - Sell when price breaks below lower band after squeeze - Works best when volatility is expanding **W-Bottoms and M-Tops:** - W-bottom: First low at/below lower band, second low inside bands - M-top: First high at/above upper band, second high inside bands - Both are reversal patterns with band context [WARNING] Bollinger Bands are NOT buy/sell signals by themselves. They show volatility and relative price position. Combine with other analysis. ### Band Width as Volatility Measure [FORMULA] Band Width = (Upper Band - Lower Band) ÷ Middle Band × 100 - High bandwidth = high volatility - Low bandwidth = low volatility (potential squeeze) [EXERCISE] A stock is trading in a range. Bollinger Bands have narrowed to their tightest point in 3 months. Suddenly, price breaks below the lower band on heavy volume. What's the likely implication? |ANSWER| A squeeze followed by a downside breakout often leads to a significant decline. The low volatility compression released in the downward direction. This is a bearish signal suggesting the stock could continue falling. [SCENARIO] You're watching a strong uptrending stock. Price has "walked" along the upper Bollinger Band for 3 weeks, repeatedly touching and slightly exceeding it. Now price falls to the middle band (20-day SMA). Is this bearish? Not necessarily. In strong uptrends, pullbacks to the middle band are often buying opportunities. The 20-day SMA can act as support. Watch if price bounces from the middle band—that confirms the uptrend is intact. If it breaks below and heads toward the lower band, then reassess.