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.\n\nConstruction:\n\n- Middle Band = 20-period SMA\n- Upper Band = 20-period SMA + (2 x 20-period standard deviation)\n- Lower Band = 20-period SMA - (2 x 20-period standard deviation)\n\nStatistically, approximately 95% of price observations fall within 2 standard deviations, so prices touching the bands represent relative extremes.\n\nThe Squeeze:\n\nA 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.\n\nWorked Example:\nPortfolio analyst Samir monitors Whitfield Pharma (WPH), trading at $64:\n\n20-day SMA: $63.50\n20-day standard deviation: $0.85 (historically low; 90-day average is $2.10)\n\nBollinger Bands:\n- Upper: $63.50 + (2 x $0.85) = $65.20\n- Lower: $63.50 - (2 x $0.85) = $61.80\n- Bandwidth: $65.20 - $61.80 = $3.40 (vs. normal ~$8.40)\n\nThe bands are compressed to 40% of normal width -- a clear squeeze.\n\nDirection Clues (The Squeeze Doesn't Predict Direction):\n\nSamir uses supplementary indicators to determine which way the breakout will go:\n\n| Indicator | Reading | Implication |\n|---|---|---|\n| RSI | 58 (neutral-bullish) | Slight upward bias |\n| Volume trend | Declining for 2 weeks | Accumulation phase |\n| Price position | Above SMA | Mild bullish lean |\n| Sector momentum | Pharma sector +2.3% this week | Supportive |\n\nWPH 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).\n\nBollinger Band Strategies:\n\n1. Squeeze breakout -- Enter on the breakout direction with volume confirmation\n2. Mean reversion -- In range-bound markets, buy at the lower band and sell at the upper band\n3. Walking the bands -- In strong trends, price can ride along the upper (or lower) band for extended periods; this is NOT a reversal signal\n4. %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\n\nCommon Mistake:\nTouching 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.\n\nPractice Bollinger Band analysis in our CFA question bank.