A Short Intro
Financial markets can be a daunting realm for those unfamiliar with its jargon and concepts. Terms like "Bollinger Bands" may sound perplexing, but fear not! In this article, we’re going to take a stab at creating a short and sweet introduction to this powerful investment tool. Let's dive in!
A Little Bit of History
Let’s rewind a handful of decades to the early 1980s, when a young-ish technical analyst and author John Bollinger wrestled with trading options and getting a grip on their volatility. Fixed width trading bands were popular at the time, but to John, they were a blunt instrument for the task of capturing market dynamics, especially in options.
To remedy this, he set out to create a more refined tool; something that combined moving averages to smooth out price data, and standard deviations to measure price dispersion. The product: Bollinger Bands. In 1983, John Bollinger released his creation to the public through his book “Bollinger on Bollinger Bands” and the idea ripped through the industry, popular for its simplicity and effectiveness.
So… what are Bollinger Bands?
The Anatomy of Bollinger Bands
In short, Bollinger Bands are a technical indicator made up of three distinct lines, which are typically charted alongside an asset’s price:
Middle Band: The middle band is typically a Simple Moving Average (SMA) of the asset's price over a specific time period. This provides a smooth version of the actual price changes.
Upper Band: The upper band is calculated by adding a certain number of standard deviations to the middle band. By default, Bollinger Bands use two standard deviations, but this can be adjusted based on the trader's preference.
Lower Band: Similarly, the lower band is obtained by subtracting the chosen number of standard deviations from the middle band.
What They Tell Us
Now that we know what Bollinger Bands look like, let’s talk about why they are useful. We’ve identified three bands, two of which are very important: the Upper Band and the Lower Band. The space between these bands gives us a zone where we expect the price of that asset to be.
Outside the Comfort Zone
If the price goes outside of this zone, then we might think that something is going on. Here are the two conditions where that happens:
Overbought: This is where the price crosses the Upper Band. In other words, “the price of this asset is higher than expected.” This may indicate a market condition where this asset has been overbought and a downward correction may occur. This is considered a sell signal. At FinDrip, this signal will show up in your email as BB - SELL.
Oversold: This is where the price crosses the Lower Band. In other words, “the price of this asset is lower than expected.” This may indicate a market condition where this asset has been oversold and an upward correction may occur. This is considered a buy signal. At FinDrip, this signal will show up in your email as BB - BUY.
The Squeeze
Now, if Overbought and Oversold conditions are not enough to feed your hungry soul, we can also talk about the Squeeze. And no, it’s not a juice bar.
Here are two statements that are objectively true: When Bollinger Bands are close together, then volatility is low. When Bollinger Bands are far apart, then volatility is high.
Here is one statement that is sometimes true: Periods of low volatility tend to be followed by periods of high volatility.
When we talk about the Squeeze, we are talking about a period of low volatility, when the bands come close together and squeeze the space between them. This is often considered a precursor to a period of high volatility. And why do we care? For the most daring and adventurous traders among us, high volatility means high opportunity, and it can pay to have the checkbook ready.
Limitations
Like any technical analysis tool, Bollinger Bands have their limitations. They should not be used as standalone indicators for making trading decisions. It is crucial to combine Bollinger Bands with other technical indicators, such as oscillators or trend lines, to gain a comprehensive view of the market.
Learn More
Want to dive deeper? Check out BollingerBands.com for comprehensive material on Bollinger Bands.
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