How does the Bollinger band work ?
Developed by John Bollinger in 1980, Bollinger Bands are a technical analysis tool for trading stocks. The bands basically are volatility bands (indicators) that measure the relatively high or low of a security’s price in relation to previous trades.
This Volatility or up and down movement of the bands is measured using standard deviation. Thus it changes with increases or decreases in volatility. Also, The bands automatically widen with a price increase and narrow with a price decrease.
This dynamic nature of the Bollinger Bands makes them suitable for the trading of various securities with standard settings.
Calculations of the Bands
There are three types of bands in a Bollinger band indicator:
- The Upper Band
- Middle Band
- Lower Band.
These bands are calculated based on the standard deviations of the particular stock’s movements and the previous day’s closings.
The calculations are such that:
Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
Middle Band = 20-day simple moving average (SMA)
Lower Band = 20-day SMA – (20-day standard deviation of price x 2)
The middle band is a simple moving average calculated based on a set of 20 periods. The outer bands are usually calculated with 2 standard deviations above and below the middle band.
Other than the knowledge of these bands there are certainly other parameters and signals that one has to keep in mind while trading using the Bollinger’s band for calculating and predicting his or her profit margins, such as:
- Periods and daily charts Daily charts
- Test period: period must be so chosen that it has a mix of bull and bear markets, along with high and low volatility
- Starting equity
- Maximum number of simultaneous trades
- Position size
- Compounding profits
Along with all these, one very important aspect to keep in mind for any trader is to decide the entry and exit timings.
Let it be any indicator or strategy is important to calculate and understand when to invest one’s money and when to withdraw for maximum profit.
Similarly, while trading with Bollinger band too the generalized advised for Entry is to Buy on the day after a stock closes above the top Bollinger Band and to exit
on the Open the day after a stock closes below the lower Bollinger Band.
In spite of ease of use and good trading results, one must remember that Bollinger Bands are primarily reactive, not predictive. The bands will react to changes in price movements, either up trends or down trends, but will not predict prices. Thus one must decide on the future of the stocks based on the present scenario. Thus keeping in mind other related factors is important while deciding.