By: Montana Timpson
Bollinger Bands, a staple in many professional traders’ charting wheelhouse, view volatility as dynamic, designed to be an “envelope” of evolving price action. Active traders can utilize Bollinger Bands to help gauge whether single stock options are likely to increase or decrease in value, making the indicator an invaluable tool for many futures and options trading strategies.
Bollinger Bands are a type of statistical chart characterizing a financial instrument’s price and volatility over time using a formulaic method that was originally developed by financial analyst John Bollinger in the 1980s.
According to Bollinger, the technical analysis tool was designed to indicate if the price of a security is high or low on a relative basis and in his words, the bands “are [directly] driven by volatility.” In practice, Bollinger Bands can offer active and professional traders a higher probability of properly identifying when an asset is oversold or overbought.
Bollinger Band Calculation
At the core, Bollinger Bands measure deviation, which is why the indicator can be helpful for professional traders in diagnosing trends. One of the more common Bollinger Band calculations uses a 20-day Simple Moving Average (SMA) for the middle band, the first of three. The upper band is then 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.
If the price of the asset dips below the lower band, shares are often viewed as oversold and due for a bounce. Conversely, if the price rises above the upper band, shares are often viewed as overbought and due for a pullback. Keep in mind, however, that Bollinger Bands are just one of many information points for predicting trends, and other factors should be considered when speculating on the price of any given security.
Bollinger Band Trading Strategies
Active traders may use Bollinger Bands to gauge whether overall market volatility is increasing or decreasing as a means of evaluating whether single stock options are likely to increase or decrease in value. Bollinger Band trading strategies vary but are often implemented to help professional investors trade trends and identify breakout stocks.
Using Bollinger Bands to Help Trade Trends
Bollinger Bands can help traders spot trending markets in two ways, the first of which deals with “wide bands.” In the case of a wide band, an extended distance between the upper and lower bands suggests greater pricing volatility and as price nears band boundaries it may hint at an upcoming reversal in price. In contrast, a close above an upper band or below a lower band over a period of multiple days may suggest that trend extension is likely.
Using Bollinger Bands to Help Identify Breakouts
In contrast to the wide-open appearance of trending markets, Bollinger Bands can signal a pending breakout by exhibiting a reduced bandwidth. A breakout is a stock price moving outside a defined support or resistance level with increased volume. Essentially, when the upper and lower bands are “tight,” a market is becoming compressed. When price breaks outside the Bollinger Bands, a substantial directional move is possible.
Register now for our next live webinar as Sean Dekmar of Dekmar Trades joins Lightspeed to talk breakout stocks and patterns, and visit Lightspeed’s Active Trading Blog for more professional trading insights, guides and resources.
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