Stock market trading offers multiple opportunities to earn additional profit, especially with online trading platforms offering advanced tools and features for easy market analysis. Analysing the market is key to building a promising investment portfolio. Let’s discuss a popular analytical tool: Bollinger bands.
Bollinger band is a technical analysis tool that is used to assess the market volatility better. Bollinger bands are primarily based on three lines: a simple moving average (the middle line), and two outer bands. The two outer bands expand and contract, reflecting volatility in the market. However, Bollinger Bands go beyond these lines and as an investor understanding its working, usage and limitations is crucial.
A Brief History of Trading Bands
Before we move ahead with the usage, let’s first take a brief look at the history of these trading bands.
It is a quite popular fact about Bollinger bands that they were named after John Bollinger, a renowned technical trader who introduced this unique method of analysing the market. Bollinger came from a background in mathematics and finance. He combined the theories of these two worlds to create the unique tool that we know today as Bollinger bands.
But did you know that before the coming of Bollinger bands, there were trading bands used to capture market volatility, efficiently.
Here’s how trading bands have evolved:
The next few years, trading bands, sort of, vanished as an analytical tool. However, Hurst brought back trading bands and based on his ideas, many other traders derived unique methods of using trading bands.
In the 1970s, a new kind of trading band gained popularity; Percentage Bands. These bands analysed market volatility by showing highs and lows against user-specified percentages. Since this type of trading band was easily available, it became one of the most used trading bands of the period.
How to Use Bollinger Bands
Bollinger bands is a technical analysis tool that relies on various figures of the market to analyse price movements. To use Bollinger bands, you must first understand how they practically work:
Firstly, a simple moving average of a few days, let’s say 20 days, is calculated and placed on a line graph. Next to the simple moving average line, standard deviation points are plotted.
Now know that under Bollinger bands, the upper and lower bands are calculated by multiplying the standard deviation by two. This is done by both adding and subtracting the number from the value to plot upper and lower values, respectively. Here’s the formula: BOLU=MA(TP,n)+m∗σ[TP,n] and BOLD=MA(TP,n)−m∗σ[TP,n]. Here,
BLOU = Bollinger Upper Band
MA = Moving Average
N = Number of days in Moving Average (typically 20)
BOLD = Bollinger Lower Band
TP= Typical Price (High+Low+Close) / 3
σ[TP,n] = SD over the last n periods of TP
M = Number of SD (typically 2)
By now, you must have understood that Bollinger bands have a wide approach that makes the result on graphs reliable and close to accurate.
How to Interpret Bollinger Bands
Is knowing the formula to calculate Bollinger bands enough? Well, the answer is no. Calculating the values is the first step that helps you prepare a graph. The next step is to interpret Bollinger bands on graphs to get a clear picture of the market volatility. Here are four types of movements seen on the Bollinger bands graph that paint different pictures of the market:
Squeeze is primarily taken as a positive movement in the market. You can observe a squeeze on the graph if the three lines come close to each other. This, typically, indicates less volatility in the market thus making it a positive window to make an investment decision.
Breakouts are observed simply to understand whether the market is agile or not and can not be taken as a signal to predict market movement. Breakouts occur when price points fall outside price bands on the graph.
W bottoms also known as double bottoms indicate that the stock price has hit two low prices simultaneously. This creates a W shape on the graph, hence the name W bottoms or double bottoms. To identify W bottoms on the graph, you have to observe if the graph shows:
Price drops below the lower band, on the first occasion. This happens right before a price rebound.
Right after the drop, a second drop is marked above the lower band.
Then comes a solid rebound breaking resistance levels.
This completes the W pattern on the graph.
As the name suggests, the M top is a pattern marked on the graph in contrast to the W bottoms. This occurs when the stock price hits two highs creating an M shape. Often, these are considered a difficult pattern to interpret. However, there are a few observations that indicate a clear trend reversal. For instance: When the second high fails to reach the upper price band it, mostly, indicates a trend reversal.
Limitations of Bollinger Bands
Bollinger bands are popularly used by traders and investors across the board because of their reliable patterns. However, like any other technical analytical tool, Bollinger bands also have certain limitations. If you are planning to use Bollinger bands you must be mindful about their limitations, as well.
Take a look at some of Bollinger Bands limitations:
Fails to be a Standalone Indicator: One of the biggest limitations of Bollinger bands is that they can not be used as a standalone indicator. A trader has to use Bollinger bands in conjunction with other analytical tools and technical indicators to get a clear picture, especially market directions. Bollinger bands, when used in isolation, can raise false alarms thus negatively impacting trading or investing decisions.
Delayed Reversal Signals: Bollinger bands are widely used to identify trend reversal and this is the same area where it fails to send real-time signals. It is often observed that Bollinger bands send alerts of price reaching an upper price band, the actual market is already heading for a pullback. This becomes a challenge for traders who want to make the most of market trends by trading timely.
Inconsistency in Signals: Another limitation of Bollinger bands is that it does not provide continuation in signals i.e. there are no signals to understand whether a certain trend reversal is temporary or likely to continue. This leaves the trader to use their discretion and guesswork, making the tool not viable for beginners with a limited understanding of the market.
Requires Subjective Interpretation: One aspect of Bollinger bands that must be clear is that it is primarily based on the movement of lines to showcase either broad or narrow bandwidth. What becomes a challenge for traders is to evaluate what can be considered broad or narrow. This simply requires subjective interpretation that requires experience in using Bollinger bands. Again, not reliable for beginners.
Conclusion
Over the years, stock market trading has become more accessible and easy even for beginners. This has been possible because of quick market analysis with tools like Bollinger bands. By providing insight into market trends and patterns, Bollinger bands help traders make an informed choice. Despite its limitations, traders can benefit from these trading bands by focusing on understanding expansion and contraction on the graph and leveraging other technical indicators simultaneously.
To embark on your journey as a trader, opening a demat and trading account with a reliable broking platform is needed. Make sure to choose the broking platform smartly to get access to advanced tools and quick updates on your portfolio.
