Bollinger Bands
SMA with standard deviation bands -- squeezes, band walks, breakouts, and why touching the band is not a signal.
What are Bollinger Bands?
Bollinger Bands are three lines drawn on the price chart: a simple moving average in the middle, with an upper band and lower band placed at a fixed number of standard deviations above and below. The bands automatically widen when the price is volatile and narrow when the price is calm.
This self-adjusting behavior makes Bollinger Bands useful for identifying two key conditions: squeezes (when the bands narrow, signaling low volatility and a potential breakout) and band walks (when the price rides along the upper or lower band during a strong trend).
How They're Calculated
In plain English: calculate the SMA of the closing price over the last N candles -- that is the middle band. Then calculate how spread out the closing prices were over the same window (the standard deviation). Add K standard deviations to the SMA for the upper band, subtract K for the lower band.
The default settings are N=20 (period) and K=2 (standard deviations). With these defaults, in theory roughly 95% of closing prices fall within the bands -- though in practice, with price's fatter tails, it is usually somewhat less.
The Squeeze
When volatility drops, the standard deviation shrinks and the bands move closer together. This is called a "squeeze." A squeeze does not predict direction -- it signals that the market is coiling and a larger move may follow in either direction.
Traders watch for squeezes because periods of low volatility are followed by periods of high volatility. The squeeze itself is not a trade signal -- it is an alert to be ready. The direction of the breakout (whether price exits through the upper or lower band) determines the trade direction.
Band Walks
During a strong trend, the price can ride along the upper band (in an uptrend) or the lower band (in a downtrend) for many candles. This is called a "band walk." The price touches or slightly exceeds the band on each candle, and the band itself moves in the trend direction.
Parameters
Common Uses
Mean reversion in ranges
In a ranging market, buy when the price touches the lower band and sell when it touches the upper band. This works because in a range, the price oscillates around the SMA. This approach fails during trends (band walks), so pairing with a trend filter is important. See Mean Reversion.
Breakout trading
Watch for a squeeze, then enter when the price breaks decisively through one of the bands. The squeeze indicates low volatility (the calm before the storm), and the band break indicates the direction of the move.
Volatility awareness
Even without generating direct trade signals, Bollinger Bands give you a visual sense of how volatile the market is right now compared to its recent history. Wide bands = volatile. Narrow bands = calm. This context helps you calibrate your expectations and stop-loss levels.
Things to Watch Out For
Bollinger Bands are based on past data
The SMA and standard deviation use historical closing prices. The bands show where volatility has been, not where it is going. A squeeze shows that recent volatility was low -- the breakout direction is not determined by the bands.
Standard deviation assumes normal distribution
The "95% of prices within 2 standard deviations" rule assumes returns are normally distributed. Financial returns have fatter tails than a normal distribution, meaning extreme moves beyond the bands happen more frequently than the statistical theory predicts.
Where to Go Next
ATR (Average True Range) -- an alternative volatility measure for setting stop-loss levels.
Volatility Indicators Overview -- all 4 volatility indicators available in Simula.
Mean Reversion -- strategies that use Bollinger Band bounces.
Volatility (Metric) -- the portfolio-level volatility calculation in your results.