Last Updated on September 27, 2023 by BFSLTeam BFSLTeam
As a trader or investor, understanding market volatility is critical to making informed decisions about buying or selling assets. One tool that has become increasingly popular in recent years is the Bollinger bands indicator. In this blog post, we’ll take a closer look at what Bollinger bands are, how they are calculated, how to interpret them, and their limitations.
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What are Bollinger Bands?
Bollinger bands are a technical analysis tool used to measure market volatility. They are named after their creator, John Bollinger, who introduced them in the 1980s. Bollinger bands consist of three lines: the middle band, which is a simple moving average (SMA) of the asset price over a given time period; the upper band, which is the middle band plus a specified number of standard deviations; and the lower band, which is the middle band minus the same number of standard deviations.
Example of Bollinger Band
Bollinger bands plotted on a daily price chart of one of the Nifty 50 companies – Reliance Industries Limited (RELIANCE):
In this chart, the green line represents the 90-day moving average, which is the middle Bollinger Band. The upper and lower Bollinger bands are two standard deviations away from the moving average, represented by the dashed lines above and below the blue line.
As we can see from the chart, the price of RELIANCE has often touched or crossed the upper and lower bands, indicating high levels of volatility. Traders can use these bands to identify potential reversal points, as well as to manage their trades by setting stop-loss orders outside the bands. Additionally, the middle band can act as a support or resistance level, providing traders with a sense of the overall trend of security.
Overall, Bollinger bands can be a useful tool for analyzing the price movements of Nifty 50 companies like RELIANCE and can help traders make more informed decisions about when to buy or sell a security.
How to Calculate Bollinger Bands?
To calculate Bollinger Bands, you need to first choose a time period (typically 20 days) and a number of standard deviations (typically 2). Then, follow these steps:
- Calculate the simple moving average (SMA) of the asset price over the chosen time period.
- Calculate the standard deviation of the asset price over the same time period.
- Calculate the upper band by adding 2 standard deviations to the SMA.
- Calculate the lower band by subtracting 2 standard deviations from the SMA.
The Bollinger bands formula is
Middle Band = SMA
Upper Band = Middle Band + (2 x SD)
Lower Band = Middle Band – (2 x SD)
where SD is the standard deviation.
How to Interpret Bollinger Bands?
Bollinger bands can be used in several ways to interpret market volatility. Here are some common strategies:
- Volatility Breakout: When the asset price breaks above the upper band or below the lower band, it is considered a sign of high volatility and a potential trend reversal.
- Mean Reversion: When the asset price reaches the upper or lower band, it is considered overbought or oversold, respectively, and may be due for a reversal back towards the middle band.
- Squeeze: When the distance between the upper and lower bands narrows, it is considered a sign of low volatility and a potential upcoming trend reversal.
Limitations of Bollinger Bands
While Bollinger bands can be a useful tool for analyzing market volatility, there are some limitations to keep in mind. These include:
- Lagging Indicator: Bollinger bands are based on past price data and may not accurately predict future market movements.
- False Signals: Bollinger bands can produce false signals during periods of low volatility, as the upper and lower bands may not accurately reflect the asset’s true range.
- Not Suitable for All Assets: Bollinger bands may not be suitable for assets with low trading volumes or those that are highly volatile.
Final Thought
In conclusion, Bollinger bands are a powerful technical analysis tool that can help traders identify potential trading opportunities and gauge the volatility of a security. By using the upper and lower bands to identify overbought and oversold conditions, traders can make more informed trading decisions and manage risk more effectively. However, like any technical indicator, Bollinger bands should be used in conjunction with other tools and analyses to confirm trading signals and minimize the risk of false signals. With its versatility and wide application, Bollinger bands remain a popular and valuable tool in the toolkit of many traders and investors.
Disclaimer: Investments in securities markets are subject to market risks, read all the related documents carefully before investing.
