Bollinger Bands are volatility indicators comprised of three smoothed lines.
Bollinger Bands measure the relative high or low of a security's price in relation to previous trades.
Generally, the closer the stock price is to the upper band, the more "overbought" the market; the closer the stock price is to the lower band, the more "oversold" the market.
Understanding Bollinger Bands
Developed by technical trader John Bollinger in the 1980s, Bollinger Bands are a type of chart indicator that has been widely used in technical analysis. The indicator can be applied in many markets, including stocks, futures, and currencies.
Bollinger Bands are comprised of three lines – the upper, middle, and lower band. As it is shown in the above image, the middle band is a simple moving average (SMA) of the price over a defined period. The upper and lower bands are plotted at a defined standard deviation level above and below the simple moving average.
(The Simple Moving Average (SMA) is formed by calculating the arithmetic average price over a certain period of time and using those points to create a smoothed line. For example, for a five-day moving average, the average of each five-day subset is calculated, and then a line is drawn that connects those data points.)
Bollinger Bands have two parameters, Period and Standard Deviations. Most trading applications use a 20-period moving average and two standard deviations as default values. However, traders can customize the parameter combinations.
Bollinger Bands are a volatility indicator that measures the relative high or low of a security's price in relation to previous trades. When the markets become more volatile, the bands widen; during less volatile periods, the bands contract.
How to use Bollinger Bands
When the bands tighten during a period of low volatility, a sharp price move in either direction becomes more likely, which may begin a trending move. When the bands separate by an unusual amount, volatility increases, and any existing trend may end.
As a trending move is formed, the potential price action in the immediate future occurs between the upper and lower bands of Bollinger Bands.
Technical analysis traders believe that the closer the stock price is to the upper band, the more "overbought" the market; the closer the stock price is to the lower band, the more "oversold" the market.
The price exceeding the upper band means a higher possibility of dropping, which could be a selling signal. The converse is true for price breaking the lower band.
Bollinger Bands can also be used to determine how strong the rising or falling trend is. For example, if an uptrend is strong enough, it will reach the upper band regularly and vice versa.
What's more, Bollinger Bands could be used to predict when the price trend is potentially reversing or losing strength. Generally, a price in the uptrend should not touch the lower band, and if it does, it is a warning signal for reverse or that the stock is losing strength.
Limitations of Bollinger Bands
Although Bollinger Bands are a helpful tool for technical traders, traders should consider a few limitations before using them.
Like most technical indicators, Bollinger Bands are a lagging indicator. The bands will not predict prices as it only reacts after the price movements.
The Bollinger Bands are not intended to be used as a standalone trading method.0John Bollinger recommends using them along with two or three other non-correlated indicators, such as intended MACD and RSI, that provide more direct market signals. He believes it is crucial to use indicators based on different types of data.
The default parameters' values of Bollinger bands are 20-day SMA and 2 standard deviations--don't guarantee to work for every security in every market. Traders are advised to adjust SMAs and standard deviation assumptions in real market trading.