TECHNICAL ANALYSIS TECHNICAL ANALYSIS BASIC EDUCATION

The Basics of Bollinger Bands®

By INVESTOPEDIA STAFF | Updated Dec 12, 2019

In the 1980s, John Bollinger, a long-time technician of the markets, developed the technique
of using a moving average with two trading bands above and below it. Unlike a percentage
calculation from a normal moving average, Bollinger Bands® simply add and subtract a
standard deviation calculation.

Standard deviation is a mathematical formula that measures volatility, showing how the
stock price can vary from its true value. By measuring price volatility, Bollinger Bands® adjust
themselves to market conditions. This is what makes them so handy for traders; they can
find almost all of the price data needed between the two bands.

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Understanding a Bollinger Band®

Bollinger Bands® consist of a centerline and two price channels (bands) above and below it.
The centerline is an exponential moving average; the price channels are the standard
deviations of the stock being studied. The bands will expand and contract as the price action
of an issue becomes volatile (expansion) or becomes bound into a tight trading pattern Ad
(contraction).
A stock may trade for long periods in a trend, albeit with some volatility from time to time. To
better see the trend, traders use the moving average to filter the price action. This way,
traders can gather important information about how the market is trading. 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.

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We know that markets trade erratically on a daily basis even though they are still trading in
an uptrend or downtrend. Technicians use moving averages with support and resistance
lines to anticipate the price action of a stock.

Upper resistance and lower support lines are first drawn and then extrapolated to form
channels within which the trader expects prices to be contained. Some traders draw straight
lines connecting either tops or bottoms of prices to identify the upper or lower price
extremes, respectively, and then add parallel lines to define the channel within which the
prices should move. As long as prices do not move out of this channel, the trader can be
reasonably confident that prices are moving as expected.

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 1:59

Understanding Bollinger Bands

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When stock prices continually touch the upper Bollinger Band®, the prices are thought to be
overbought; conversely, when they continually touch the lower band, prices are thought to
be oversold, triggering a buy signal.

When using Bollinger Bands®, designate the upper and lower bands as price targets. If the
price deflects off the lower band and crosses above the 20-day average (the middle line), the
upper band comes to represent the upper price target. In a strong uptrend, prices usually
fluctuate between the upper band and the 20-day moving average. When that happens, a
crossing below the 20-day moving average warns of a trend reversal to the downside.

Examples of Bollinger Bands®

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Figure 1

Source: MetaStock

You can see in this chart of American Express (NYSE: AXP) from the start of 2008 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 had not been broken.

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Figure 2

Source: MetaStock

In the 2001 chart of Microsoft Corporation (Nasdaq: MSFT) (above), you can see the trend
reversed to an uptrend in the early part of January, but look at how slow it was in showing
the trend change. Before the price action crossed over the centerline, the stock price had
moved from $20 to $24 and then on to between $24 and $25 before some traders would have
confirmation of this trend reversal.

This is not to say that Bollinger Bands® aren't a well-regarded indicator of overbought or
oversold issues, but charts like the 2001 Microsoft layout are a good reminder that we should
start out by recognizing trends and simple moving averages before moving on to more exotic
indicators.

The Bottom Line

While every strategy has its drawbacks, Bollinger Bands® have become one of the most Ad
useful and commonly used tools in spotlighting extreme short-term prices in a security.
Buying when stock prices cross below the lower Bollinger Band® often helps traders take
advantage of oversold conditions and profit when the stock price moves back up toward the
center moving-average line.

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Related Terms
Envelope Definition
Envelopes are technical indicators plotted over a price chart with upper and lower bounds. more

Trading Channel Definition

A trading channel is drawn using parallel trendlines to connect a security's support and resistance
levels within which it currently trades. more

Stoller Average Range Channel Bands - STARC Bands Definition and

Uses
Stoller Average Range Channel Bands (STARC Bands) is a technical indicator that plots two bands
around a short-term simple moving average (SMA). The bands provide an area the price may move
between. more

Bollinger Band®
A Bollinger Band® is a set of lines plotted two standard deviations (positively and negatively) away
from a simple moving average of the security's price. 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

Keltner Channel Definition and Tactics

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

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