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You might have heard, “Investments are subject to market risk” a lot of times due to the volatile nature of the market. Even the markets enjoy their gala time playing- idhar chala main, udhar chala quite often with us. Now, is there a way to understand how volatile a financial asset is currently? The answer is, YASS! One way to know this is with an indicator called the Bollinger bands. So, hop on to learn more.
Mr John Bollinger developed this tool in the 1980s. Bollinger bands are a lagging indicator as it follows the price movement. It acts as an envelope around the price. These bands can tell us about the volatility in the price. It uses standard deviation as a measure of volatility. When the bands are expanding i.e. moving away from each other, the volatility is said to be high. When the bands are contracting i.e. moving closer to each other, the volatility is said to be low. Just have a look at Nestle India’s daily chart below and check how the Bollinger bands expanded, as the Maggi ban case unfolded in June 2015.
1.The Middle band – The middle band is a 20-day simple moving average (SMA).
2.The Upper band - The upper band is simply 2 standard deviations above the middle band. The standard deviation is taken for the same period as SMA i.e. 20 days.
3.The Lower Band – The lower band is simply 2 standard deviations below the middle band. The standard deviation is taken for the same period as SMA i.e. 20 days.
In an ongoing uptrend, price tends to move between the upper and the middle band. If there is a strength in the move it may go beyond the upper band. The price tends to take support at the middle band. One can explore buying opportunities when the price rebounds from this support or gives a breakout with other firm bullish signals.
This can be observed at various points (marked with a tick) on the daily chart of TCS between 16th March 2020 to 15th April 2021 below. Targets can be set using Pivot points or Fibonacci levels. How to do that? We have already discussed it in our YouTube videos. Check it here. Let's continue with our discussion, a trend reversal is possible when the price gives a breakdown at the middle/lower band with other confirmatory bearish signals from support/resistance levels, patterns, indicators (MACD, RSI, etc.).
The opposite holds in an ongoing downtrend, where the price tends to move between the lower band and the middle band. If the weakness is more it may go beyond the lower band. The middle band may act as a resistance. One can explore shorting opportunities when the price rebounds from this resistance or gives a breakdown at the middle band with other firm bearish signals.
This can be observed at various points (marked with a tick) on the daily chart of Tata steel between 25th July 2014 to 5th November 2015 below. Targets can be set using Pivot points or Fibonacci levels. A trend reversal is possible when the price gives a breakout at the middle/upper band with other confirmatory bullish signals from support/resistance levels, patterns, indicators (MACD, RSI, etc.).
BB squeeze is nothing but Bolinger Band squeeze. BB squeeze happens when the volatility is low and the bands are closer to each other. According to John Bollinger, periods of low volatility are often followed by periods of high volatility. Hence, with an increase in volatility, the price can move either way. If there’s a breakout at the upper band, the price tends to move up and creates buying opportunities with firm bullish confirmations. If there’s a breakdown at the lower band, the price tends to move down and creates shorting opportunity with firm bearish confirmations. The longer the duration of the squeeze, the higher will be the strength in the move. This can be observed on the daily chart of Kotak Mahindra Bank between 13th June 2019 to 24th September 2019 which was followed by an up move and between 23rd October 2019 to 3rd March 2020 which was followed by a down move.
You might have heard this phrase called “Walking the bands” often while discussing BB. But, what exactly does it mean? To put it simply, when the candles are being formed on the upper/lower bands (i.e. the candles overlap the band borders), then the price is said to be walking the bands. It tells us whether the price is high or low. When the price is walking on the upper band it is said to be relatively high and is commonly observed in an uptrend. When the price is walking on the lower band it is said to be relatively low and is commonly observed in a downtrend. However, these moves do not necessarily mean buy/sell signals. It simply tells us about the strength or the weakness in the moves. Below is the daily chart of Praj Industries.
Bottom Line
Well, by now you would have already guessed that BB should not be used solely to make buy/sell decisions. You will have to take multiple confirmations from other parameters like candlestick and chart patterns, MACD, RSI, etc. You might have caught that false breakouts are also possible in BB.
If you are following the blogs, you must have noticed that you have started sounding like a Technical analyst! So, if technical analysis intrigues you, make sure to click on the link to check out my course where I have explained more patterns, indicators, and strategies in the most simplified way. Until next time!
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