Bollinger bands are a technical indicator that help investors gauge whether a stock is overpriced or under priced compared to it’s historical trading level.
The indicator has three lines: an upper line, a middle line, and a lower line.
The middle line represents the moving average of the stock, while the upper and lower lines represent a number of standard deviations away from the average.
In the screenshot to the right, you’ll see an example of Bollinger Bands in action.
This image shows the a candle chart of the S&P 500 index (Ticker $SPX), with each bar representing one week of data. Overlayed on this chart are the upper line in red, the middle line in yellow, and the lower line in green which together represent the Bollinger Band indicator.
By default, most Bollinger bands are set at a 20 period moving average, with lines at 2 standard deviations above and below the moving average.
However, this default setting does not result in a reliable trading signal for three reasons:
The first is that 20 trading periods is too short of a window for the S&P 500 to reliability revert to its average price.
The second is that 2 standard deviations is not a wide enough range to prevent false positives. The stock market is so volatile that price movements 2 standard deviations away from the average are more common than the average investor realizes.
Example chart with Bollinger Bands on the S&P 500 Index using the Thinkorswim platform
The third reason is that these settings cannot be applied equally to all charts. For example, a 1 minute chart with a 20 period moving average would show the average over 20 minutes. But if your chart frequency is 1 hour, then your 20 period moving average would show the average over 20 hours, or about 2.5 days of trading. In either case, the stock market does not reliably revert back to its 20 minute or 2.5 day moving average.
Example settings for Bollinger Band indicator using the Thinkorswim platform
So what settings should we use?
There is no “one best setting,” but if you have a specific strategy, you can adjust the Bollinger Band indicator to match your approach. The strategy that I have had the most success with involves the stock market’s one year moving average, and much wider standard deviations.
My thesis is that while day-to-day, week-to-week, and even month-to-month, the stock market can fluctuate wildly, it tends to trend upward on a yearly basis. And no matter how drastic the headlines are over a given period, the market continues to march upward, on average, year after year.
So here are the settings I use, with a visual example of this in the image to the left:
Now that we have a strategy in place, let’s look at how this indicator has performed over time using the S&P 500 index as an example.
During the 5 years between 2018 and 2023, this Bollinger Band indicator triggered 3 times.
During the 5 years between 2008 and 2013, this Bollinger Band indicator triggered once in late 2008.
This was during the Great Recession of ‘08 and ‘09, which saw a ~45% decline in the stock market from top to bottom.
During that time, the indicator triggered at ~900, and through 2013 rose to new highs of ~1,800 and above for a total gain of ~100%.
Unfortunately, I wasted this opportunity attending High School band practice when I should have been investing in stocks and real estate…
During the 5 years between 2001 and 2006, this indicator triggered 2 times.
Through 2006, the index climbed to ~1,400, representing a ~47% and ~65% gain on each entry point, respectively.
Note: the index also fell below the lower line earlier in 2001 at ~1,100. However, it did not close below the lower line, and therefore did not trigger an entry. Regardless, the total gain from that point through 2006 is still ~27%. Not bad for a trigger happy investor.
During the 5 years between 1980 and 1985, the Bollinger Band indicator triggered once.
This occurred in mid-1981 at a level of ~110…how crazy is that to think the S&P 500 was in the 100s and is now over 4,000 to 5,000!
From that point through 1985, the index climbed to new highs of ~190, for a 73% increase.
Unfortunately, I missed out on this amazing investment opportunity as I was not even a concept in my young parents’ minds at the time.
During the 5 years between 1970 and 1975, the Bollinger Band indicator triggered once.
This happened in mid-1970 at the bottom of that market cycle around the ~70 point. From there, the market quickly surged to a new high of 120 for a ~71% gain.
However, the market turned down again, and did not trigger the lower band.
This highlights the importance of knowing when to deleverage, take your gains “off the table,” and wait patiently for the next trigger.
This is also an example of how this indicator will not always trigger on every downturn.
During the 5 years between 1966 and 1971, the Bollinger Band indicator triggered 2 times.
During the 5 years between 1961 and 1966, the Bollinger Band indicator was triggered 2 times in quick succession.
Given the nature of the strategy and the proximity of these triggers, I will only count the first trigger. I can’t assume that after just 1 or 2 weeks you have just as much capital to buy the second or third dip.
From ~60 in 1962, the index went on to reach ~95 in 1966, for a total gain of ~58%.
Bollinger Bands is one of the best technical indicators for buying the dip. Just like any other indicator, Bollinger Bands are only effective if you have a proven investment strategy and adjust the indicator settings to match that strategy. As shown in this write up, Bollinger Bands have historically been a highly reliable and profitable indicator for buying into market dips over various five year periods going back to the 1930s. Specifically, these examples use a 52-week moving average, and trigger when the S&P 500 closes below the lower band during a given week.