Narrator: Bollinger Bands® are a technical indicator that can help you define trends and measure the volatility of securities like stocks.
In this video, we'll explain how Bollinger Bands are calculated and applied, and address the benefits and risks of using this indicator.
Animation: A bell curve shows the standard deviations of returns. The significant majority of the bell curve fall within two standard deviations on either side of the middle.
Narrator: The bands are calculated using standard deviation from a moving average. Standard deviation is a statistic used in probability theory and is commonly applied in financial markets to measure volatility.
In financial markets, standard deviation measures the volatility of returns from a historical average, or a mean, such as a 20-day moving average.
Bollinger Bands are typically plotted two standard deviations above and below a moving average.
This means about 95% of a security's historical price movement is likely contained within the two bands.
This information can help you add context to trends and potentially determine when they might be overextended and reverse.
Because the bands typically contain about 95% of a security's price movement, it's unusual, but possible, for the price to move outside the bands.
But when it does, probability theory assumes the security price is likely to revert back to a moving average, or a mean, between the upper and lower bands. This is called mean reversion and some investors might use it to make trading decisions.
Let's look at an example of how you may be able to identify entry and exit points using Bollinger Bands.
On-screen disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.
Narrator: A potential entry point can be set up when the price of a security falls below the lower band.
Here, an investor might wait for the price to close back above the band before entering the trade. This is a form of confirmation when applying mean reversion strategies.
A reversion to the mean is complete when the security rises back to its moving average. Some investors use this as an exit point.
Others might target the upper band as an exit point, which is typically a bigger profit target and can take longer to achieve.
Investors using the upper band as a target might look for confirmation by letting the price move above the upper band and then waiting for a close back below the band before exiting a trade.
The idea is that a break back below the upper band is likely to revert to the moving average.
Some investors look for additional confirmation by considering the slope of the bands.
Put in simple terms, if the bands are sloping up, then the security is in a potential uptrend.
Conversely, if the bands are sloping down, then the security is in a potential downtrend.
So, by referring to the slope, some investors might only take entry points in uptrends and ignore entry points in downtrends.
Timing entry and exit points in these ways is one of the main benefits of applying Bollinger Bands.
Additionally, the bands can help investors visualize statistical properties of securities and help identify when prices move unexpectedly two standard deviations away from a moving average.
Keep in mind that these deviations can last for long periods of time, which is one of the biggest risks of using Bollinger Bands.
Remember that probability theory assumes that security prices are mean reverting, but this assumption frequently breaks down in the real world.
On-screen disclosure: For illustrative purposes only. Not a recommendation of any security or strategy.
Narrator: Here's a typical example of a security that has fallen to its lower band, or two standard deviations away from its moving average.
Notice how the price continues falling along its lower band before eventually returning to the moving average.
A mean reversion can take a long time, and during that time, the price of a security can continue falling.
That's why investors typically avoid taking entry points every time a security falls below the lower band. Using Bollinger Bands as a standalone indicator is risky.
For a more balanced approach, an investor might consider using Bollinger Bands to add context to trends and help time entry and exit points that arise from other forms of analysis such as fundamentals and the market's overall trend.
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