‘When to enter?
When to exit?
Decide before buying,
Else you won’t be able to fix it.’
This is a common motto when investing in stocks. You need to know when to enter the market and time your exit for maximum possible returns. Various tools and techniques are used to time these trading decisions. Bollinger Bands are one such tool that helps you with this endeavour. Let’s deep dive into what it is, and how it works.
This article covers:
- Bollinger Bands meaning
- Statistical techniques used in Bollinger Bands
- How are Bollinger Bands calculated?
- Importance of Bollinger Bands
- Situations wherein Bollinger Bands do not work effectively
Bollinger Bands meaning
Bollinger Bands are mathematical formulae based on three statistical terminologies that assist investors in trading decisions with respect to ‘when to enter and exit?’ from a particular stock.
‘Bollinger’ comes from the last name of John Bollinger – the trader who invented this technique. The term ‘bands’ is added to it because the method calculates the upper and the lower price range in a graphical format, typically using a straight line. This creates a band that helps you make the right trading decision.
Statistical techniques used in Bollinger Bands
There are two terminologies that you have to understand for grasping Bollinger Bands meaning. These terms are also used in the formula to create the band. They are as follows:
It’s a statistical term arrived at by calculating the square root of the variance. In trading, standard deviations of a stock tell you how volatile it is. So, to say that stock A has a higher standard deviation than stock B is to mean that the former is more volatile than the latter.
Simple moving average (SMA)
The prices of the stock during a particular duration divided by the quantity of the prices gives you the simple moving average of that stock. So, say stock A’s closing prices across a week were Rs 310, Rs 320, Rs 330, Rs 340 and Rs 350, then its simple moving average would be 310 + 320 + 330 + 340 + 350 divided by 5 i.e., 330.
Now, let’s look at how these two terms are used in creating Bollinger Bands.
How are Bollinger Bands calculated?
- Begin by calculating the simple moving average of stock as mentioned above.
- Then, measure the standard deviations by calculating the square root out the variance – an average of the squared differences of the mean.
- Multiply the standard deviation by the digit 2 and then add as well as subtract the amount from each point along the SMA to find the upper and the lower Bollinger Bands.
There are three lines in a stock’s graph that constitute Bollinger Bands:
a) the upper Bollinger Band
b) the lower Bollinger Band and
c) the SMA
- Upper Bollinger Band i.e. BOLU = MA (TP,n) + m ∗ σ [TP,n]
- Lower Bollinger Band i.e. BOLD = MA (TP,n) – m ∗ σ [TP,n]
- MA = Moving average
- TP (typical price) = (Highest price during the day + Lowest price during the day + Closing price at that day) ÷ 3
- n = number of days in smoothing period which is generally 20
- m = number of standard deviations that are normally equal to 2
- σ [TP,n] = standard deviation over last n periods of Typical price
Importance of Bollinger Bands
Most of the time, what investors wish to know before entering or exiting a certain stock is whether the market is overbought or oversold. By plotting the upper Bollinger Band and the lower Bollinger Band, one can exactly tell which band among the two is the current price of the stock closer to.
Say, if the current stock price is closer to the upper Bollinger Band, it hints towards the stock being overbought and vice versa. Depending on whether it is overbought or oversold, investors can decide whether to sell or buy the stocks.
Situations wherein Bollinger Bands do not work effectively
Although Bollinger Bands promise to offer deep insights to an investor about a particular stock’s current position, it has its own set of limitations.
To start with, there are scenarios wherein all the three bands are extremely close / very far from each other. These are times that investors generally term the market as either highly volatile or non-volatile (stagnant). In such scenarios, the bands give no indication or direction.
Then, there are conditions wherein the stock price rises above or below the upper Bollinger Band and the lower Bollinger Band, respectively. In such a situation too, the investor doesn’t get a clear idea of what to make of it, and whether they must trade or not.
Remember, Bollinger Bands are not able to operate independently. They just indicate to investors regarding the volatility of a stock price. You may need to use it in combination with other indicators to get more definitive signals.
Bollinger Bands trading techniques give crucial information to the investor by pointing out an upper and lower limit, within which it can be considered a safe zone to enter or exit while a particular stock is trading. However, you need to combine Bollinger Bands trading techniques with other tools to get a suitable and more holistic indication for trading in the stock exchange. Nonetheless, for measuring volatility, this technique would help you find out how volatile a stock is.
Understand what Bollinger Bands are all about and what they depict so that you can be an informed trader. It would also allow you to use the best of trading practices for wealth creation through risk management. Speak to your financial advisor before you take positions in the stock market.