Bollinger Bands explained simply

John Bollinger developed Bollinger Bands in the 1980s. They consist of a middle line and one band above and one below it. How far the bands sit from the middle depends on how much the price has been swinging lately.

What it's about

The middle line is a 20 day moving average. The bands show the range the price normally moves in. When the price swings a lot, the bands spread far apart. When it's calm, they squeeze together.

An example: a stock's bands have been close together for weeks. Many traders pay close attention then, because calm phases are often followed by a bigger move. Which direction, the bands don't tell you.

How it's calculated

First you work out the average of the last 20 closing prices. Then you look at how far prices typically deviate from that average. That number is called the standard deviation. The upper band sits two standard deviations above the middle, the lower band two below.

With numbers: the average is €50, the standard deviation €1.50. The upper band is then at €53, the lower at €47.

What signals traders read from it

• Touching the lower band: Some see a chance of a move back to the middle, especially in sideways phases.
• Tight bands: When the bands are tighter than they've been for a long time, many expect a breakout soon.
• Riding the band: If the price closes near the upper band day after day, that points to a strong uptrend.

Where it misleads you

The upper band isn't a ceiling and the lower one isn't a floor. In a strong trend the price often rides along the band for weeks. If you trade against the trend every time because the price is at the band, you lose again and again.

The rule of thumb that about 95 percent of prices stay inside the bands only holds if price moves follow a normal distribution. They don't. Big outliers happen far more often in markets than that calculation assumes.

An example trade with made up numbers

Sara has €10,000 in her account and risks at most €150 per trade. A stock has been moving sideways for weeks and touches the lower band at €42. Sara buys, expecting a return to the middle line at €45. She sets her stop loss at €40.50. With €1.50 of risk per share, she buys 100 shares for €4,200. Costs: €1 each to buy and sell, plus about 2 cents of spread per share on each order.

If it works: The price reaches the middle line at €45. Sara is €300 ahead. After €2 in fees and €4 in spread, €294 is left.

If it goes wrong: The sideways phase turns into a downtrend and the price rides the lower band down. The stop fills at €40.40. That's a €160 loss, €166 with costs.

The idea behind the trade, back to the middle, only works in sideways phases. Whether you're in one, you only know for sure afterwards.