How do Bollinger Bands work, and what does a band squeeze indicate about upcoming price movement?

Bollinger Bands consist of a middle band (simple moving average) flanked by upper and lower bands set at a specified number of standard deviations from the mean. They dynamically adjust to volatility, widening during volatile periods and contracting during quiet periods.

Construction:

• Middle Band = 20-period SMA
• Upper Band = 20-period SMA + (2 x 20-period standard deviation)
• Lower Band = 20-period SMA - (2 x 20-period standard deviation)

Statistically, approximately 95% of price observations fall within 2 standard deviations, so prices touching the bands represent relative extremes.

The Squeeze:

A Bollinger Band squeeze occurs when the bandwidth (distance between upper and lower bands) contracts to a historically narrow range. This indicates that volatility has compressed, and the statistical tendency is for volatility to revert to the mean -- meaning a significant price move is likely.

Worked Example: Portfolio analyst Samir monitors Whitfield Pharma (WPH), trading at $64:\n\n20-day SMA:$63.50 20-day standard deviation: $0.85 (historically low; 90-day average is$2.10)

Bollinger Bands:

• Upper: $63.50 + (2 x$0.85) = $65.20**\n- Lower:$63.50 - (2 x $0.85) = **$61.80
• Bandwidth: $65.20 -$61.80 = **$3.40** (vs. normal ~$8.40)

The bands are compressed to 40% of normal width -- a clear squeeze.

Direction Clues (The Squeeze Doesn't Predict Direction):

Samir uses supplementary indicators to determine which way the breakout will go:

Indicator	Reading	Implication
RSI	58 (neutral-bullish)	Slight upward bias
Volume trend	Declining for 2 weeks	Accumulation phase
Price position	Above SMA	Mild bullish lean
Sector momentum	Pharma sector +2.3% this week	Supportive

WPH breaks above the upper band at $65.20 on 2.5x average volume. This confirms a bullish breakout. Samir enters long with a stop at the lower band ($61.80).

Bollinger Band Strategies:

1. Squeeze breakout -- Enter on the breakout direction with volume confirmation
2. Mean reversion -- In range-bound markets, buy at the lower band and sell at the upper band
3. Walking the bands -- In strong trends, price can ride along the upper (or lower) band for extended periods; this is NOT a reversal signal
4. %B indicator -- Measures where price sits relative to the bands: %B = (Price - Lower) / (Upper - Lower). Values above 1.0 or below 0.0 indicate band penetration

Common Mistake: Touching the upper band is NOT automatically a sell signal. In strong uptrends, price frequently walks along the upper band. Use Bollinger Bands for volatility assessment, not as rigid buy/sell triggers.

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