Bollinger Bands: What It Is, How to Use It and Chart Examples

Bollinger Bands is a technical indicator that shows price volatility and range through three lines: a moving average in the middle, plus an upper and lower band calculated from price standard deviation. Traders use it to see when price is relatively expensive or cheap compared to its average, and when volatility is contracting or expanding.

What Bollinger Bands are

Bollinger Bands were created by John Bollinger in the 1980s as a statistical method for reading price and volatility of a financial instrument over time. The concept is simple: calculate the average price over N periods, then add and subtract that average by the standard deviation multiplied by a factor K to form the upper and lower bands.

The purpose, according to Bollinger himself, is to give a relative definition of high and low prices in a market. Price is considered high when it's near the upper band and low when it's near the lower band. This definition is what traders use to recognize price patterns more systematically rather than just eyeballing the chart.

The name "Bollinger Bands" was registered as a US trademark in 2011. The indicator is used across stocks, forex, crypto, and even options markets, since the volatility concept applies across asset classes.

The formula and basic rules

Bollinger Bands consist of three main components. Here's the formula step by step:

Standard deviation here measures how far price spreads from its average. The wider the price spread, the larger the standard deviation, and the wider the gap between the upper and lower bands.

Two indicators are commonly derived from Bollinger Bands:

1. %b, calculated as: %b = (last price - lower band) / (upper band - lower band). Its value is 1 when price sits exactly at the upper band, and 0 at the lower band. This helps gauge price's relative position within the bands without eyeballing the chart.
2. Bandwidth, calculated as: Bandwidth = (upper band - lower band) / middle band. This shows how wide the bands are on a normalized basis, useful for comparing volatility levels across different time periods.

With the default setting of 20 periods and 2 standard deviations, bandwidth mathematically equals four times the 20-period coefficient of variation.

How to read it on the chart

There are several common reading approaches, and they're not all the same:

• Mean reversion: buy when price touches the lower band, exit when price returns to the middle band. The logic is that price is considered too low relative to its average and likely to revert to the middle.
• Breakout: buy when price breaks above the upper band, or sell when price breaks below the lower band. The logic is the opposite of mean reversion, a band breakout is seen as a sign of fresh strong momentum.
• Squeeze: when the upper and lower bands converge, it signals low volatility. This condition often precedes a big move, though the direction isn't predetermined.
• Band walking: when the bands move nearly parallel and price keeps hugging one band for an extended period, it usually signals a strong trend continuing rather than a reversal.

Signals weaken when the market is sideways without clear direction, since price can bounce between both bands repeatedly without meaningful trend significance. Breakout signals should also be treated with caution if the breaking candle closes with a small body or is quickly followed by a sharp reversal, since that could be a false breakout.

Common settings used

The most standard setting is 20 periods with 2 standard deviations, using a simple moving average as the base. EMA (exponential moving average) is the most common second choice when traders want the middle band to react faster to recent price.

Period and standard deviation are usually adjusted when the tracked asset has a volatility character far different from the market average, like a small altcoin that moves much more wildly than a blue chip stock.

Step-by-step how to use it

1. Open a chart on TradingView or a trading/brokerage app, then find "Bollinger Bands" in the indicator menu.
2. Choose a timeframe matching your trading style, such as 15 minutes for scalping, 4 hours for intraday, or daily for swing trading.
3. Keep the default setting of 20 and 2 if you're still learning, then adjust once you're familiar with that asset's character.
4. Observe price's position relative to all three bands, and also note band width to read the volatility condition.
5. Wait for candle close before drawing conclusions from a band touch or breakout, don't decide while the candle is still forming.
6. Match the Bollinger Bands signal with another indicator or price action before finalizing an entry plan.
7. Set stop loss and target levels first, before execution, so the risk management plan is clear from the start.

Chart examples

Example 1 (illustration, mean reversion). Say a coin's price moves sideways around Rp15,000,000 with the middle band at that same level, lower band at Rp14,400,000, and upper band at Rp15,600,000. Price drops and touches the lower band at Rp14,400,000, and a trader enters a buy there with a stop loss at Rp14,150,000 and target at the middle band of Rp15,000,000. Risk is about Rp250,000, potential reward about Rp600,000, roughly a 1:2.4 risk reward ratio.

Example 2 (illustration, breakout from a squeeze). Say a stock's upper and lower bands narrow to only Rp50 apart from a price of Rp2,000, signaling low volatility. Price then breaks above the upper band to Rp2,060 with a large candle body and volume above average. A trader enters a buy at Rp2,060, sets a stop loss at Rp2,010 (below the band), and a target at Rp2,160 based on the band width before the squeeze. Risk is Rp50, reward Rp100, a 1:2 risk reward ratio.

Both figures above are purely illustrative to explain how to calculate risk reward, not real market data and not a recommendation to buy or sell any specific asset.

What it means for traders

A few concrete things worth tracking when using Bollinger Bands day to day:

• Band width (bandwidth), not just a touch on the band. A prolonged squeeze often precedes a bigger move, though the direction isn't guaranteed either way.
• Candle close on the timeframe being used, before treating a breakout as valid. This avoids getting caught by a wick that quickly reverses after touching the band.
• Current market condition, whether it's band walking (strong trend) or sideways, before choosing between a mean reversion or breakout approach. Using the wrong strategy for the context is one of the most common causes of losses.
• Stop loss and target levels set before entry, so the risk reward ratio is already measured from the start instead of shifting with emotions as price moves.
• Exchange opening hours for IDX stocks, since opening gaps can jump past the bands without gradually touching them the way crypto often does trading 24 hours.
• Supporting indicators like RSI or volume to filter signals, instead of stacking as many indicators as possible which only makes decisions harder.

Combining with other tools

• Bollinger Bands with RSI: used to filter mean reversion signals. If price touches the lower band and RSI also shows oversold, the buy signal is considered stronger than relying on one indicator alone.
• Bollinger Bands with volume: useful for validating breakouts. A breakout above the upper band accompanied by a volume spike is generally considered more valid than one with thin volume.
• Bollinger Bands with trendlines or chart patterns: used so the band signal doesn't stand alone. If a breakout from the bands aligns with the direction of the main trendline, this combination provides extra confirmation before entry.
• Bollinger Bands with trend indicators like ADX: ADX helps determine whether the market is trending or sideways, which is useful for deciding whether a breakout or mean reversion strategy fits better at that moment.

Common mistakes

• Treating every band touch as an automatic buy or sell signal, when in a sideways market price can bounce between both bands repeatedly without clear direction.
• Entering before candle close, when a candle still in progress can change shape and invalidate a signal that looked valid moments earlier.
• Using a mean reversion strategy during a strong trend, when in a band walking condition price can keep hugging one band without returning to the middle for a long time.
• Ignoring the bigger timeframe context, such as taking a buy signal on a small timeframe while the main trend on a larger timeframe is falling sharply.
• Trading without a stop loss because of too much confidence price will revert to the middle band, when reversion to the mean is never guaranteed.
• Stacking too many indicators on top of Bollinger Bands so the resulting signals contradict each other and make decision-making harder.

Strengths and limitations

Bollinger Bands' strength lies in its simplicity for reading volatility and relative price position, plus its flexibility across stocks, crypto, forex, and even options. The indicator also has derivatives like %b and bandwidth that can be used to build more systematic trading rules.

Its limitation is that Bollinger Bands remains a lagging indicator since its calculation is based on historical moving average and standard deviation data, not future data. A study by Lento and colleagues in 2007 on Dow Jones data and forex markets since 1995 found that the standard Bollinger Bands strategy did not consistently beat a buy and hold approach, though a contrarian version of the strategy actually showed positive results across various markets. Another study in the Chinese market found similar results, where the contrarian version of the Bollinger Band rule delivered positive returns after accounting for transaction costs of 0.50 percent.

Signal outcomes can also differ significantly across timeframes for the same asset, and no single Bollinger Bands setting is always correct in every market condition. For crypto that trades 24 hours, the bands keep moving without pause, while for stocks on the Indonesia Stock Exchange, opening gaps can make price jump straight past the bands without gradually touching them the way it usually appears on intraday charts.