Bollinger Bands are a technical indicator used for evaluating changing prices of stock market investments.  It is based on the notion that every stock has a natural variation in day-to-day trading but that when something significant happens, the stock will trade outside the normal range of variation.  The band suggest an upper and lower limit on what would be considered normal price variation and tells the investor whether a price change should suggest a trading action or whether the investment should be left as is.

Bollinger Band Chart Example

Developed by John Bollinger in the 80’s, the concept is to determine the relative “highness” or “lowness” of a price compared to recent trading activity.  The bands themselves are composed of three elements:  a moving average based on a specific number of prior periods, an upper band and a lower band.  The upper and lower bands are generally related to the standard deviation (a statistical measurement of change) of the price variations of the moving average during the prior periods.  All of the variables can be adjusted by the investor to find the exact model the investor wished to examine.

The math can be a little complex and the investor is advised to use a service to provide the actual bands.

Bollinger Band Trading Strategies:

The use of the bands is different for each investor.  Some investors will sell when the upper band is reached or buy when the lower band is reached.  This assumes that there are no significant changes in the underlying market value and that the stock price will tend to move back towards the moving average.

Other investors will do the opposite, buying at the top band and selling at the lower band.  The logic behind this approach is that the price movement outside the band indicates that some underlying fact or event has caused that change in price and that the price will continue to move in the same direction. 

Other investors will buy or sell when the price of a stock moves across the moving average, indicating that there is a change in the evaluation of the price by the market.

You as an investor do not have to respond to every movement in the exact same way.  You may, for example, know what has caused the price to move outside the normal range and allow that to help you decide on a strategy for that specific stock. 

Advantages of Using Bollinger Bands:

The critical advantage to you when you use Bollinger Bands is that they will tell you when a stock price movement is outside the normal range of price variation.  It allows you to know when to look at an investment and conversely, when to let it ride.  How you respond to that information is up to you to determine.

Overall, the use of Bollinger Bands as one of the tools in your investment strategy can be very helpful.  A suggestion is that you track the movements in and out of the Bollinger Bands on historical data for some of the stocks in your portfolio to see how they have reacted.  A little study and test work will stand you in good stead before you actually commit money to the technique.

Bollinger Bands, however complex they are, are a valuable tool to the investor.