Bollinger bands

The Bollinger bands are used to display stock price volatility on a chart. They are: the middle band, which is a simple moving average (SMA), the upper band, which is the SMA plus the standard deviation (times 2) and the lower band, which is the SMA minus the standard deviation (times 2). For more info on moving averages, please take a look at the moving averages post. The Bollinger bands were created by a fellow named John Bollinger and we thank him for that.

Let's say talk for a moment about standard deviation since it is at the heart of those Bollinger bands. Standard deviation is, as its name implies, a measure of how much sample values differ from the average. For each period (day on a daily chart), the deviation is obtained by subtracting the simple moving average (SMA) from the price. If you take the sum of the squared deviations divided by the number of periods and then the square root of that number, you obtain the standard deviation. Standard deviation indicates volatility, that is, how much the price varies from its average. The more it varies, the more volatile the stock is (more possible returns but also more risk). The less it varies, the less volatile the stock is (less risk but also less possible returns).

The Bollinger bands give an immediate idea of how volatile the stock is. The wider the bands are, the more volatile the stock is. Inversely, the narrower the bands, the less volatile the stock is. Volatility is important in short-term trading since the more volatile the stock is, the more important the returns can be and the more risky the trade can be. Volatility is also key in stock option pricing but we will not delve into this fascinating subject ... for now!

The Bollinger bands can also be used as a trade decision tool. If the price walks up/down the band (the prices are touching or slightly breaking the upper band in an uptrend or the lower band in a downtrend), the Bollinger bands are giving a continuation signal. When the price moves away from the band it is walking up/down, it is a possible signal the trend is running out of steam. A buy signal can be forthcoming when the price forms a double bottom into the low zone (between the middle and lower bands) and the second low doesn't break the lower band. The signal is confirmed when the price breaks the middle band to the upside. Similarly, a double top in the high zone (between the middle and the upper bands) indicates a signal to sell when the price dips below the middle band. When the bands contract (squeeze), a breakout is imminent but you usually don't know in which direction the stock is gonna go unless a price pattern is also present. A contraction of the bands, indicating lower volatility, may lead to a spectacular uptrend or downtrend.