Bollinger Bands were created by John Bollinger in the 1980s as a method for traders to identify extreme short-term prices in security. The indicator is created by plotting the average of the predetermined member of prices along with two trading bands below and above. The outer bands are created by adding and subtracting one standard deviation from the moving average. The upper and lower bands are typically two standard deviations +/- from a 20-day simple moving average. They can be modified. Note also that there are three lines that compose Bollinger Bands: a simple moving average (middle band), and an upper and lower band.
Standard deviation is used to create this indicator because it is a common measure of volatility. Under normal conditions, traders will always find the price of the security to trade within the bands. The bands will expand and contract as the price action of the security under discussion becomes volatile. This process is called expansion. Or the price of the security becomes bound in a tight trading range. This process is called contraction.
When using Bollinger Bands, traders should bear in mind that periods of low volatility generally tend to be followed by periods of high volatility and vice versa. That is, if the trader sees that Bollinger Bands start to get close to one another, there is a chance that the volatility will increase, bringing trading opportunities in its wake.
Another method of using Bollinger Bands is to know when the price of the security moves beyond the upper or lower barriers. When the price moves above the upper band, prices are overbought and might soon pull back. Conversely, a move below the lower band suggests that prices are oversold. In this case, traders might consider buying the security.
What Do Bollinger Bands Tell you?
The closer the prices move to the upper band, the more overbought the market is. The closer the prices move to the lower band, the more oversold the market is. Because standard deviation is a measure of volatility, when the markets become more volatile, the bands widen. During less volatile periods, the bands contract.
The squeeze is a concept central to understanding how Bollinger Bands operate. When the bands pinch together, they constrict the moving average. This is called a squeeze. As a rule, a squeeze signals a period of low volatility. Traders view it as a potential sign of future increased volatility and of lucrative trading opportunities. When bands move apart, volatility usually decreases, signaling the possibility of exiting a trade. Note that these conditions are not trading signals. Bollinger Bands do not signal when the change may happen or which direction prices will go.
About 90% of price movement occurs between the two bands. Traders should watch for the price breaking above or below the bands. This is when trading opportunities appear. But note that the breakout is by no means a trading signal. Do not interpret the price exceeding one of the bands as a signal to buy or sell. Remember that breakouts do not inform traders about the direction and extent of future price movement.
Advantages and Disadvantages of Bollinger Bands
Traders should not rely only on Bollinger Bands when making trading decisions. This system provides you only with the information about price volatility. Always use Bollinger Bands together with other indicators giving more direct market signals. Bollinger bands are computed from a simple moving average. This means that they give the same weight to the most recent and the older data. The new information, therefore, may be diluted by outdated data. The use of 20-day SMA and two standard deviations are arbitrary and are not equally applicable to every trading situation. Make sure to adjust your SMA and standard deviation assumptions and do not forget to monitor them.
Bollinger Bands is considered a helpful, top trading tool. Identifying prices that move above or below the band helps traders take advantage of unjustifiably high or low prices. It is also important for traders to monitor shifts in volatility. Of all trading methods, Bollinger Bands accomplishes this most effectively.