Bollinger bands were originally developed and popularized by John Bollinger in the early 1980s. The technical concept of using price envelopes, or “bands,” and moving averages was not new, but Bollinger introduced significant improvements in his bands that has improved their usefulness and made this one of the “go-to” indicators used by technical analysts in any capital market.
This article and the accompanying video will focus on two common uses for the technical indicator that can be used to improve your trading.
Bollinger bands are comprised of a moving average (usually 20-periods by default), and an upper and lower band that envelopes the price action.
The bands are placed two standard deviations away from the moving average. This means that Bollinger bands are able to show price movement and volatility changes, both of which are important trading signals.
The bands themselves do not necessarily generate trading signals, but can help traders to understand where prices and volatility is now relative to where it has been in the recent past.
I’ll illustrate two examples of how this information can be used to adjust trades or to take action.
Using Bollinger Bands to Identify Price Extremes
Within a given trend, prices will periodically “correct” or retrace before continuing. It is very common for these retracements or corrections to stop at the upper Bollinger band in a downtrend or the lower Bollinger band in an uptrend.
These extremes represent price levels at which a new position could be initiated in favor of the prevailing trend. Similarly, these extremes may indicate a high risk environment for short-term counter-trend trades.
In the chart below for Google Inc. (GOOG), you can see this retracement and continuation behavior during a downtrend. As prices hit the upper Bollinger band they were at high risk of reversing in favor of the previous trend.
This is common and can be an effective way to identify periods of high risk or trading opportunities.
Using Bollinger Bands to Identify Periods of Emerging Volatility
The previous example illustrated how Bollinger bands can be used to identify potential changes in price. These bands can also be used to identify periods when volatility changes are likely.
The indicator does this by showing when volatility is reaching extreme lows relative to its recent history. Technicians look for these low volatility periods as consolidations and trade the breakout trends when volatility comes back to the market.
Bollinger bands show these periods of extremely low volatility or consolidations by moving toward each other and “squeezing” together.
Using Bollinger bands like this makes it very easy to visually identify those periods when the market is more likely to breakout in the near term.
This is important from a risk-control perspective, as well as a way to identify trading opportunities. Option traders may use these squeezes as a signal for long straddles or strangles, which need high volatility to be profitable.
You can see a great example of a squeeze on the SPDR Gold Trust ETF (GLD) below.