- It is a technical indicator used to analyse the stock market.
- This indicator consists of three lines. The middle line is the simple moving average (SMA). The upper and the lower lines are set two standard deviations away from the moving average on either side.
- The two standard deviations are taken from the 20-period simple moving average.
Formulae for Bollinger Band Indicator:
- Upper Bollinger Band = MA[TP, n] + m*σ[TP, n]
- Lower Bollinger Band = MA[TP, n] – m*σ[TP, n]
- MA = Moving Average;
- TP = Typical Price = (High + Low + Close)/3;
- n = number of periods chosen (generally 20);
- m = number of standard deviations (generally 2);
- σ[TP, n] = standard deviation of TP oven last n periods.
This is the 1 day chart of Maruti Suzuki India around Jan-Aug, 2020
- Standard deviation measures volatility. If the bands widen, it indicates that there is a high price volatility and if the bands contract, it indicates that there is less price volatility.
- Moreover, when the price is closer to the upper band, it indicates that the stock is overbought. Existing traders try to exit their long positions and initiate long unwinding. New traders enter the market by initiating their short positions.
- When the price moves closer to the lower band, it indicates that the stock is oversold. Existing traders exit their short positions and initiate short covering. New traders enter the market by initiating their long positions.
- However, the above trading tricks would turnout to be successful only when the Bollinger bands widen, as it indicates price volatility.
- When the gap between the bands is less, it is called a squeeze. Traders are advised not to trade when there is a squeeze, as there is less price volatility.
- A squeeze often indicates a future increased volatility and better trading options but it doesn’t indicate the time at which the bands widen. Hence they should not be considered as trend signals.
- The main disadvantage of Bollinger bands is that nothing can be interpreted from the breakouts. Price often trades between the bands.
- When there is a breakout, many traders feel there is a potential trading option available but it leads to false results because the future price trend can’t be interpreted from the breakouts.
- Also, the indicator is based on the historic data. It is calculated using the past 20 periods and it acts as a lagging indicator. Nothing can be inferred about the future price direction.
- Therefore Bollinger bands need to be clubbed with few other indicators to better analyse the stock market.