Bollinger Bands (BB) is a popular technical indicator created by John Bollinger that helps determine whether prices are high or low on a relative basis.
Bollinger Bands (BB) were created in the early 1980s by trader, analyst, and professor John Bollinger.
The indicator filled the need to visualize changes in volatility.
Traders generally use Bollinger bands to determine overbought and oversold zones, to confirm divergences between prices and indicators, and to project price targets.
Bollinger bands consist of a band of three lines that are drawn relative to prices.
The 3 lines:
- Upper Band
- Middle Line
- Lower Band
The line in the middle is usually a simple moving average (SMA) set over a 20-day period
The SMA then serves as the basis for the upper and lower bands.
The Upper and Lower Bands are used as a way to measure volatility by looking at the relationship between the Bands and the price.
Usually the upper and lower bands are set at two standard deviations from the SMA (the middle line), but can usually be adjusted by the trader.
As volatility increases, the wider the bands become. Also, as volatility decreases, the gap between the bands narrows.
Period (20): the number of bars, or period, used to calculate the study. John Bollinger recommends an optimal period of 20 or 21 periods and cautions that periods of less than ten periods do not seem to work well.
Bandwidth (2): the average width of the band in terms of multiples of standard deviation. Typically, “2” is used.
First, calculate a simple moving average. Next, calculate the standard deviation (SD) for the same number of periods as the simple moving average (SMA).
For the upper band, add the standard deviation (SD) to the simple moving average (SMA). For the lower band, subtract the standard deviation (SD) from the simple moving average. (SMA)
Typical values used:
- Short-term: 10-period moving average, bands at 1.5 standard deviations. (1.5 times standard development +/- SMA)
- Medium-term: 20-period moving average, bands in 2 standard deviations.
- Long term: 50-period moving average, bands at 2.5 standard deviations.
How Bollinger Bands Work
- When the bands tighten during a period of low volatility, the probability of a sharp price movement in either direction increases. This can start a trend movement. Watch out for a wrong move in the opposite direction that is reversed before the proper trend begins.
- When the bands spread by an unusually large amount, volatility increases, and any existing trends may be ending.
- Prices tend to bounce within the band envelope, touching one band and then moving to the other band. You can use these changes to help identify potential profit targets. For example, if a price bounces off the lower band and then crosses above the moving average, the upper band becomes the profit target.
- The price can exceed or hug a band wrap for extended periods during strong trends. In the event of divergence with a momentum oscillator, you may want to conduct additional research to determine if additional profit is appropriate for you.
- A strong continuation of the trend can be expected when the price moves outside the bands. However, if prices immediately move back within the band, then the suggested force is nullified.
How to use Bollinger bands
Traders generally use Bollinger bands to determine overbought and oversold zones, to confirm divergences between prices and studies, and to project price targets.
The wider the bands, the greater the volatility. The narrower the bands, the lower the volatility.
Some traders use Bollinger Bands with other technical indicators, such as RSI.
- If the price touches the upper band and the other technical indicator does not confirm the bullish movement (that is, there is divergence), a sell signal is generated.
- If the other technical indicator confirms the bullish movement, no sell signal is generated and indeed a buy signal may be indicated.
- If the price touches the lower band and the other technical indicator does not confirm the downward movement, a buy signal is generated.
- If the other technical indicator confirms the downward movement, no buy signal is generated, and indeed a sell signal may be indicated.
Another strategy is that of the Bollinger Bands themselves.
- In this approach, an upper part of the chart that is above the upper band followed by an upper part below the upper band generates a sell signal.
- On the other hand, a lower part of the chart that occurs below the lower band followed by a lower part above the lower band generates a buy signal.
- Bollinger Bands also help determine overbought and oversold markets.
When prices approach the upper band, the currency pair becomes overbought, and as prices approach the lower band, the currency pair becomes oversold.
Price momentum must also be taken into account. When a price enters an overbought or oversold area, it can turn even further before reversing.
Bollinger bands are made up of a middle band (SMA) and upper and lower bands based on standard deviation (SD) that contract and widen with volatility.
Bands are a useful tool to analyze the strength of the trend and monitor when a reversal may be occurring.
However, Bollinger Bands are not predictive. They are always based on historical information and therefore react to price changes, but do not anticipate price changes.
Like other indicators, Bollinger Bands are best used in conjunction with other indicators, price analysis, and risk management as part of an overall business plan.