Bollinger Bands are a highly popular and versatile technical analysis tool used by traders and investors to gauge the volatility of a financial instrument and identify potential overbought or oversold conditions, as well as possible trend continuations or reversals. Developed by John Bollinger in the 1980s, they adapt to market conditions, unlike fixed-width trading bands that were common at the time.

At their core, Bollinger Bands consist of three lines plotted on a price chart:

1. Middle Band: This is typically a Simple Moving Average (SMA) of the asset’s price. The most common period used is 20, meaning it’s the average closing price over the last 20 periods (e.g., 20 days for a daily chart, 20 hours for an hourly chart). This middle band serves as a measure of the asset’s intermediate-term trend.

2. Upper Band: This band is plotted a specific number of standard deviations above the middle band.

3. Lower Band: This band is plotted the same specific number of standard deviations below the middle band.

How They Are Calculated (Typical Settings):

While the period for the moving average and the number of standard deviations can be customized, the most widely used settings are:

• Period (N): 20 (for the SMA and standard deviation calculation)
• Standard Deviations (K): 2

The formulas are as follows:

• Middle Band: $SMA(Close,N)$
• Upper Band: $SMA(Close,N)+(K\times StandardDeviation(Close,N))$
• Lower Band: $SMA(Close,N)-(K\times StandardDeviation(Close,N))$

Where:

• $Close$ is the closing price of the asset.
• $N$ is the number of periods (e.g., 20).
• $K$ is the number of standard deviations (e.g., 2).
• $SMA$ is the Simple Moving Average.
• $StandardDeviation$ measures the dispersion of prices from the mean (SMA).

Key Interpretations and Principles:

1. Volatility Indicator:

   • Expanding Bands (Wider Bands): When the bands widen, it indicates increased volatility in the market. This often occurs during strong trends or significant price movements.
   • Contracting Bands (Narrower Bands / “Bollinger Squeeze”): When the bands narrow and come closer together, it signals decreased volatility. This often precedes a significant price move or “breakout” in either direction, as the market is consolidating before a new trend emerges.

2. Relative High and Low Prices:

   • Price at the Upper Band: By definition, when the price touches or goes above the upper band, it is considered relatively high. This can suggest an overbought condition, but it’s crucial to note that prices can “walk the band” during strong uptrends, meaning they can hug or even briefly move outside the upper band for extended periods.
   • Price at the Lower Band: Similarly, when the price touches or goes below the lower band, it is considered relatively low. This can suggest an oversold condition, but prices can “walk the band” during strong downtrends.

3. Mean Reversion:

   • A common principle is that prices tend to revert to the mean (the middle band). When prices touch an outer band, there’s an expectation that they might eventually move back towards the middle band.

Common Trading Strategies and Observations:

• Bollinger Squeeze (Breakout Strategy): As mentioned, a period of low volatility (narrow bands) often precedes a period of high volatility. Traders look for the bands to squeeze tightly together, indicating an imminent breakout. A move decisively above the upper band could signal a bullish breakout, while a move below the lower band could signal a bearish breakout.
• Reversals and Overbought/Oversold:
  • While a touch of a band doesn’t automatically mean a reversal, it can be a strong indicator when combined with other signals. For example, if price touches the upper band and then a bearish candlestick pattern forms, it might suggest a reversal.
  • John Bollinger himself emphasizes that “There is absolutely nothing about a tag of a band that in and of itself is a signal.” Traders should look for non-confirmation with other indicators or specific chart patterns.
• “Walk the Band” (Trend Following): During strong trends, prices can consistently ride along one of the outer bands. In an uptrend, prices might stay between the middle and upper band, or even touch the upper band repeatedly. In a downtrend, prices might stay between the middle and lower band, or repeatedly touch the lower band. This indicates strong momentum in the direction of the trend.
• W-Bottoms and M-Tops: These are specific chart patterns that John Bollinger identified using the bands to signal reversals:
  • W-Bottom: A bullish pattern where the price makes a low, bounces, makes a second low (which is often lower than the first but holds above the lower band), and then moves strongly upwards, confirming the reversal.
  • M-Top: A bearish pattern where the price makes a high, pulls back, makes a second high (which is often higher than the first but inside the upper band), and then moves strongly downwards, confirming the reversal.
• Confirmation with Other Indicators: Bollinger Bands are most effective when used in conjunction with other technical indicators. For instance:
  • Combining with Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) can help confirm overbought/oversold conditions or trend strength/weakness.
  • Using Volume can provide further confirmation; for example, a breakout on high volume is generally more reliable.

Limitations:

• Lagging Indicator: Like most indicators based on moving averages, Bollinger Bands are lagging indicators, meaning they reflect past price action and do not predict future prices.
• Not Standalone: Relying solely on Bollinger Bands for trading decisions is generally not recommended. They provide context but should be combined with other analysis tools and strategies.
• Customization: While customizable, finding the optimal settings (period and standard deviations) for a specific asset or timeframe can require experimentation. The default settings may not be ideal for all situations.

In essence, Bollinger Bands provide a dynamic and visually intuitive way to understand an asset’s price action in relation to its historical volatility. They help traders identify potential trading opportunities by highlighting when prices are relatively high or low, when volatility is contracting or expanding, and when trends might be forming or reversing.