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John Bollinger, CFA, CMT, has been a major influence in technical analysis and is best known for developing Bollinger Bands in the 1980s. He is also the founder of Bollinger Capital Management, a money management company, and has been a prominent commentator and analyst on market conditions. In range-bound markets, mean reversion strategies can work well, as prices travel between the two bands like a bouncing ball. However, Bollinger Bands® don’t always give accurate buy and sell Initial exchange offering signals.
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The chart thus expresses arbitrary choices or assumptions indicator tools for trading of the user, and is not strictly about the price data alone. For example, when the stock breaks through the upper band, some traders believe this generates a buy signal (breaking through a resistance level). When it breaks below the lower band, some traders believe this is a sell signal (breaking through a support level). As the chart shows, the S&P 500 is currently still inside of the bands.
Construction of Bollinger Bands
It’s worth noting that Bollinger believes a close either above the band or below the band is not necessarily a reversal signal, but rather a continuation pattern. Currently, the S&P 500 is in the middle part of the band, which suggests US https://www.xcritical.com/ stocks are neither overvalued nor undervalued based solely on this indicator (see Bollinger Bands applied to the S&P 500® Index chart below). When the upper and lower Bollinger Bands are moving towards each other, or the distance between the upper and lower bands is narrow (on a relative basis), it is a suggestion that the market under review is consolidating. From a practical application perspective, Bollinger Bands are extremely flexible. Today the most popular approaches to trading bands are Donchian, Keltner, percentage, and, of course, Bollinger Bands.
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To better see the trend, traders use the moving average to filter the price action. This way, they can gather important information about how the market is moving. For example, after a sharp rise or fall in the trend, the market may consolidate, trading in a narrow fashion and crisscrossing above and below the moving average. To better monitor this behavior, traders use the price channels, which encompass the trading activity around the trend.
Common mistakes while using Bollinger Bands
Recently, the S&P 500 has trended lower, and a move toward the lower band might generate a buy signal. They can be used in the creation of your own trading systems and approaches. They are used by traders around the world and across many different markets in a wide array of approaches.
In the double top (or M top) we tend to look at the price which breaches the upper Bollinger band before decreasing for a while and then increasing again. The traders will check if the second rise closes below the upper Bollinger band and only then will they short the asset. Usually, traders hone in when the price breaches the lower band and rebounds for a short while before diving again.
In the 2001 chart of Microsoft (MSFT) below, you can see the trend reversed to an uptrend in the early part of January. Before the price action crossed over the centerline, the stock price moved from $20 to $24 and then on to between $24 and $25 before some traders would have confirmation of this trend reversal. You can see that for the most part, the price action was touching the lower band and the stock price fell from the $60 level in the dead of winter to its March position of around $10. In a couple of instances, the price action cut through the centerline (March to May and again in July and August), but for many traders, this was certainly not a buy signal as the trend wasn’t broken.
In this article, we show you how to use the Bollinger Bands ® indicator to improve your chart reading skills and how to identify high-probability trade entries. While Bollinger Bands provide valuable technical insights, they don’t consider fundamental factors affecting an asset. Ignoring fundamental analysis can lead to missed opportunities or unexpected market reactions. Also, it is observed from the strategy that the cumulative returns is -2.52%. Negative cumulative returns indicate that the strategy, based on the Bollinger Bands signals, has not been profitable during the observed period, and the overall performance has resulted in a loss. Unlike the strategy discussed above, where you know the direction of the trend, it can be hard to predict which direction the price would go after a period of low volatility.
- The first number (20) sets the periods for the simple moving average and the standard deviation.
- In the chart below, notice how the Bollinger Bands are on a squeeze pattern and suddenly BOOM!
- John Bollinger, CFA, CMT, has been a major influence in technical analysis and is best known for developing Bollinger Bands in the 1980s.
- Economic announcements, earnings reports, geopolitical events, or sudden shifts in market sentiment can be behind these changes.
- When I started working in the markets percentage bands were the most popular choice.
- Therefore, only small adjustments are required for the standard deviation multiplier.
- When an asset is oversold that means that there is too much selling going on, in other words, cheap.
The reason for the second condition is to prevent the trend trader from being „wiggled out“ of a trend by a quick move to the downside that snaps back to the „buy zone“ at the end of the trading period. To help remedy this, a trader can look at the overall direction of price and then only take trade signals that align the trader with the trend. For example, if the trend is down, only take short positions when the upper band is tagged.
Here is a brief look at the differences, so you can decide which one you like better. Similar to the double bottom which is focused on the lower Bollinger band, the double top occurs at the upper Bollinger Band. The double top formation is a rare occurrence compared to the double bottoms which were seen earlier. Bollinger Bandwidth is effectively used to identify the Bollinger Band squeeze. In addition to the Bollinger Bands, John Bollinger has said that we should look at the bandwidth of the band too, to help us in our analysis.
The authors did, however, find that a simple reversal of the strategy („contrarian Bollinger Band“) produced positive returns in a variety of markets. When the bands widen, this signals an increase in volatility because the standard deviation of the price increases. For investors using mean reversion strategies, the upper band can act as a price target in a ranging market. If the price oscillates between the upper and lower bands without a clear trend, hitting the upper band can signal to sell or go short because traders expect the price to move back toward the middle band or below.
The longer the squeeze, the more potent the subsequent breakout is expected to be. This is based on the principle that periods of low volatility are frequently followed by periods of high volatility. The lower band of the Bollinger Bands helps identify oversold conditions. It is also a reference line for those using mean reversion strategies or looking for potential reversals. If prices stay below this band, this could mean the start of a new bearish trend, especially if there’s a lot of trading volume.
Bollinger Bands have default settings, but these settings may not be optimal for all assets or timeframes. Traders should adjust the parameters (e.g., the moving average period and standard deviation multiplier) to better suit the asset and trading style they are using. By default, the overlay uses a 20-period SMA and sets the bands 2.0 standard deviations above or below the SMA. These parameters can be adjusted to meet your technical analysis needs. The stock broke down in January with a support break and closed below the lower band. From mid-January until early May, Monsanto closed below the lower band at least five times.
Percentage bands are quite simple, a moving average shifted up and down by a user-specified percent. For example, at any given time a 7% band consists of a base moving average, an upper curve at 107% of the base and a lower curve at 93% of the base. Percentage bands had the decided advantage at the time of being easy to chart by hand. A lot of new traders tend to gaze at Bollinger Bands and make the general assumption that when the price hits the upper band, it’s a sell signal and when the price hit’s the lower band, it’s a buy signal.
It’s not advisable to base yourself solely on Bollinger Bands in order to make trading decisions. John Bollinger explains that Bollinger Bands are not a standalone indicator and should always be used in combination with others. The beauty of Bollinger bands is that it checks this inside a standard deviation limit that tells us what mathematically makes sense in terms of the appropriate distance from the SMA.