Learn about the Bollinger Bands technical indicator and how it can help identify volatility and overbought/oversold conditions in stocks and indices.
Bollinger Bands are a technical analysis indicator that’s widely used by traders and investors. Why are they so popular? Bollinger Bands are relatively simple to understand and intuitive to apply. Bollinger Bands can help measure market volatility and identify overbought or oversold conditions in stocks, indices, futures, forex, and other markets.
Bollinger Bands are typically plotted as three lines—a middle line, an upper band, and a lower band.
The middle line of the indicator is a simple moving average (SMA). Most charting programs default to a 20-day SMA, which is usually adequate for most investors, but you can experiment with different moving average lengths after you get a little experience applying Bollinger Bands.
The upper and lower bands, by default, represent two standard deviations above and below the moving average. Again, you can try out different standard deviations for the bands once you become more familiar with how they work.
Figure 1 shows Bollinger Bands applied to a price chart of the Russell 2000 (RUT).
FIGURE 1: RUSSELL 2000 (RUT) WITH BOLLINGER BANDS. The Bollinger Bands indicator applied to the price chart of the RUT uses a 20-day simple moving average (cyan line). The upper (yellow) band represents +2 standard deviations away from the moving average, and the lower (purple) band represents -2 standard deviations away from the moving average. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The upper and lower bands measure volatility, or the degree in variation of prices over time. Because Bollinger Bands measure volatility, the bands adjust automatically to changing market conditions.
The bands tend to narrow when an index goes quiet and price changes are small. At other times, the bands widen as an index becomes volatile and changes get bigger. Take a look at the chart of the Utilities Select Sector Index ($IXU) in figure 2. Notice how the bands contracted when the $IXU traded in a quiet, relatively stable fashion. Then look at how the bands expanded when the index experienced large price changes, down and up, over short periods of time.
FIGURE 2: UTILITIES SELECT SECTOR INDEX ($IXU) WITH BOLLINGER BANDS. The Bollinger Bands expanded when the $IXU became volatile and experienced large price changes over a short time period. The bands contracted when the $IXU traded in a tight range. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
It’s important to understand what makes Bollinger Bands expand and contract, because many investors use Bollinger Bands to measure when an index may be overbought or oversold. But this strategy is by no means foolproof. So, what’s the approach?
Generally, investors define a Bollinger Bands overbought condition when an index moves above the upper band. Conversely, an index may be oversold when it moves below the lower band. But here’s the catch: an index can remain overbought or oversold for an extended period. For example, take a look at figure 3, which shows the Philadelphia Gold and Silver Index (XAU) from July to early September 2018.
FIGURE 3: GOLD & SILVER INDEX (XAU) BOLLINGER BANDS. XAU dropped below its lower Bollinger Band in July 2018 and continued trending lower into early September 2018. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
XAU reached an oversold condition in July 2018 when the price bars fell below the lower band. The index continued to fall for seven weeks before stabilizing and rebounding, and the Bollinger Bands expanded in response to the increased volatility.
What’s the takeaway? When applying Bollinger Bands to measure overbought and oversold conditions, be mindful of the width of the bands. Avoid seeking overbought or oversold conditions when the bands are expanding. Instead, look for these conditions when the bands are stable or even contracting.
To this point, take another look at the XAU in figure 3 and notice how it respected the Bollinger Bands from the end of December 2018 to mid-January 2019 as the bands were contracting. During this time, when XAU moved above the upper band and became overbought, it subsequently paused and pulled back.
There are many ways to apply Bollinger Bands to your trading. So, go ahead. Add the indicator to your charts and watch how prices move with respect to the three bands. And once you’ve got the hang of it, try changing up some of the indicator parameters.
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