Using Bollinger Bands To Gauge Trends

2/5/22, 11:28 PM Using Bollinger Bands to Gauge Trends
TECHNICAL ANALYSIS

ADVANCED TECHNICAL ANALYSIS CONCEPTS
Using Bollinger Bands to Gauge Trends

By
CORY MITCHELL
Updated June 28, 2021
Reviewed by
CHARLES POTTERS
Bollinger Bands® are a type of chart indicator for technical analysis and have become widely used by traders in many markets, including
stocks, futures, and currencies. Created by John Bollinger in the 1980s, the bands offer unique insights into price and volatility. [1] In fact,
there are a number of uses for Bollinger Bands®, such as determining overbought and oversold levels, as a trend following tool, and for
monitoring for breakouts.
KEY TAKEAWAYS
Bollinger Bands® are a trading tool used to determine entry and exit points for a trade.
The bands are often used to determine overbought and oversold conditions.
Using only the bands to trade is a risky strategy since the indicator focuses on price and volatility, while ignoring a lot of other
relevant information.
Bollinger Bands® are a rather simple trading tool, and are incredibly popular with both professional and at-home traders.
Calculation of Bollinger Bands

Bollinger Bands® are composed of three lines. One of the more common calculations uses a 20-day simple moving average (SMA) for the
middle band. The upper band is calculated by taking the middle band and adding twice the daily standard deviation to that amount. The
lower band is calculated by taking the middle band minus two times the daily standard deviation.
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The Bollinger Band® formula consists of the following: Advertisement
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BOLU = MA(TP, n) + m ∗ σ[TP, n]

BOLD = MA(TP, n) − m ∗ σ[TP, n]
where:
BOLU = Upper Bollinger Band
BOLD = Lower Bollinger Band
MA = Moving average
TP (typical price) = (High + Low + Close) ÷ 3
n = Number of days in smoothing period
m = Number of standard deviations
σ[TP, n] = Standard Deviation over last n periods of TP
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Overbought and Oversold Strategy
A common approach when using Bollinger Bands® is to identify overbought or oversold market conditions. When the price of the asset
breaks below the lower band of the Bollinger Bands®, prices have perhaps fallen too much and are due to bounce. On the other hand,
when price breaks above the upper band, the market is perhaps overbought and due for a pullback.
Using the bands as overbought/oversold indicators relies on the concept of mean Advertisement
reversion of the price. Mean reversion assumes that, if
the price deviates substantially from the mean or average, it eventually reverts back to the mean price.
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Important: Bollinger Bands® identify asset prices that have deviated from the mean.
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 signals. During a strong trend, for example, the trader runs the risk of placing
trades on the wrong side of the move because the indicator can flash overbought or oversold signals too soon.
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. The lower band can still be used as an exit if
desired, but a new long position is not opened since that would mean going against the trend.
Image by Sabrina Jiang © Investopedia 2020
Create Multiple Bands for Greater Insight

As John Bollinger acknowledged, "tags of the bands are just that, tags, not signals." [2] A tag (or touch) of the upper Bollinger Band® is not
in and of itself a sell signal. A tag of the lower Bollinger Band® is not in and of itself a buy signal. Price often can and does "walk the band."
In those markets, traders who continuously try to "sell the top" or "buy the bottom" are faced with an excruciating series of stop-outs, or
even worse, ever-mounting losses as price moves further and further away from the original entry.
FAST FACT
Perhaps a more useful way to trade with Bollinger Bands® is to use them to gauge trends.
At the core, Bollinger Bands® measure deviation, which is why the indicator can be very helpful in diagnosing trend. By generating two sets
of Bollinger Bands®, one set using the parameter of "one standard deviation" and the other using the typical setting of "two standard
deviations," we can look at price in a whole new way. We will call this Bollinger Band® "bands."
In the chart below, for example, we see that whenever price holds between the upper Bollinger Bands® +1 SD and +2 SD away from mean,
the trend is up; therefore, we can define that channel as the "buy zone." Conversely, if price channels within Bollinger Bands® –1 SD and –2
SD, it is in the "sell zone." Finally, if price meanders between +1 SD band and –1 SD band, it is essentially in a neutral state, and we can say
that it's in uncharted territory.
Bollinger Bands® adapt dynamically to price expanding and contracting as volatility increases and decreases. Therefore, the bands
naturally widen and narrow in sync with price action, creating a very accurate trending envelope.
A Tool for Trend Traders and Faders

Having established the basic rules for Bollinger Band® "bands," we can now demonstrate how this technical tool can be used by both trend
traders who seek to exploit momentum and fade-traders who like to profit from trend exhaustion or reversals. Returning to
the chart above, we can see how trend traders would position long once price entered the "buy zone." They would then be able to stay in
the trade as the Bollinger Band® "bands" encapsulate most of the price action of the move higher.
As for an exit point, the answer is different for each individual trader, but one reasonable possibility would be to close a long trade if the
candle on the candlestick charts turn red and more than 75% of its body were below the "buy zone." Using the 75% rule, at that point, price
clearly falls out of trend, but why insist that the candle be red? 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.
Note how, in the following chart, the trader is able to stay with the move for most of the uptrend, exiting only when price starts to
consolidate at the top of the new range.
Bollinger Band® "bands" can also be a valuable tool for traders who like to exploit trend exhaustion by helping to identify the turn in price.
Note, however, that counter-trend trading requires far larger margins of error, as trends will often make several attempts at continuation
before reversing.
In the chart below, we see that a fade-trader using Bollinger Band® "bands" will be able to quickly diagnose the first hint of trend
weakness. Having seen prices fall out of the trend channel, the fader may decide to make classic use of Bollinger Bands® by shorting the
next tag of the upper Bollinger Band®.
As for the stop-loss points, putting the stop just above the swing high will practically assure the trader is stopped out, as the price will often
make many forays at the recent top as buyers try to extend the trend. Instead, it is sometimes wise to measure the width of the "no man's
land" area (distance between +1 and –1 SD) and add it to the upper band. By using the volatility of the market to help set a stop-loss level,
the trader avoids getting stopped out and is able to remain in the short trade once the price starts declining.
Image
Bollinger Bands Squeeze Strategy

Another strategy to use with Bollinger Bands® is called a squeeze strategy. A squeeze occurs when the price has been moving aggressively
then starts moving sideways in a tight consolidation.
A trader can visually identify when the price of an asset is consolidating because the upper and lower bands get closer together. This
means the volatility of the asset has decreased. After a period of consolidation, the price often makes a larger move in either direction,
ideally on high volume. Expanding volume on a breakout is a sign that traders are voting with their money that the price will continue to
move in the breakout direction.
When the price breaks through the upper or lower band, the trader buys or sells the asset, respectively. A stop-loss order is traditionally
placed outside the consolidation on the opposite side of the breakout.
Image
Bollinger vs. Keltner

Bollinger Bands® and Keltner Channels are different, but similar, indicators. Here is a brief look at the differences, so you can decide which
one you like better.
Bollinger Bands® use standard deviation of the underlying asset, while Keltner Channels use the average true range (ATR), which is a
measure of volatility based on the range of trading in the security. Aside from how the bands/channels are created, the interpretation of
these indicators is generally the same.

Important: One technical indicator is not better than the other; it is a personal choice based on which works best for the
strategies being employed.
Since Keltner Channels use average true range rather than standard deviation, it is common to see more buy and sell signals generated in
Keltner Channels than when using Bollinger Bands®.
The Bottom Line

There are multiple uses for Bollinger Bands®, including using them for overbought and oversold trade signals. Traders can also add
multiple bands, which helps highlight the strength of price moves. Another way to use the bands is to look for volatility contractions. These
contractions are typically followed by significant price breakouts, ideally on large volume. Bollinger Bands® should not be confused with
Keltner Channels. While the two indicators are similar, they are not exactly alike.
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Related Terms
What Is a Bollinger Band® in Technical Analysis?
A Bollinger Band® is a momentum indicator used in technical analysis that depicts two standard deviations above and below a simple moving average.
more
Bulge Definition and Uses

A bulge is the upper bound of a Bollinger Band®. It is set a specified number of standard deviations from the mid-point.
more
Keltner Channel Definition

A Keltner Channel is a set of bands placed above and below an asset's price. The bands are based on volatility and can aid in determining trend direction and
provide trade signals. more
Donchian Channels Definition

Donchian Channels are moving average indicators developed by Richard Donchian. They plot the highest high price and lowest low price of a security over a
given time period.
more
Envelope Channel
Envelope channel has evolved into a generic term for technical indicators used to create price channels with lower and upper bands.
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Moving Average (MA) Definition

A moving average (MA) is a technical analysis indicator that helps smooth out price action by filtering out the “noise” from random price fluctuations.
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2/5/22, 11:28 PM Using Bollinger Bands to Gauge Trends

Calculation of Bollinger Bands

The Bollinger Band® formula consists of the following: Advertisement

BOLU = MA(TP, n) + m ∗ σ[TP, n]

Try the Investopedia Stock Simulator

Image by Sabrina Jiang © Investopedia 2020

Create Multiple Bands for Greater Insight

Image by Sabrina Jiang © Investopedia 2020

A Tool for Trend Traders and Faders

Image by Sabrina Jiang © Investopedia 2020

Image by Sabrina Jiang © Investopedia 2020

Bollinger Bands Squeeze Strategy

Image by Sabrina Jiang © Investopedia 2020

Bollinger vs. Keltner

The Bottom Line

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TECHNICAL ANALYSIS BASIC EDUCATION

TECHNICAL ANALYSIS BASIC EDUCATION

TECHNICAL ANALYSIS BASIC EDUCATION

FOREX TRADING STRATEGY & EDUCATION

TECHNICAL ANALYSIS BASIC EDUCATION

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Bulge Definition and Uses

Keltner Channel Definition

Donchian Channels Definition

Moving Average (MA) Definition

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