Bollinger Bands are envelopes plotted at a standard deviation level above and below a simple moving average of the price. Because the distance of the bands is based on standard deviation, they adjust to volatility swings in the underlying price. Bollinger Bands use 2 parameters, Period and Standard Deviations, StdDev.
- Bollinger Bands® is a technical analysis tool to generate oversold or overbought signals and was developed by John Bollinger.
- Three lines compose Bollinger Bands: A simple moving average, or the middle band, and an upper and lower band.
- The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average and can be modified.
- When the price continually touches the upper Bollinger Band, it can indicate an overbought signal.
- If the price continually touches the lower band it can indicate an oversold signal.
Bollinger Bands are typically plotted as three lines:
- An upper band
- A middle line
- A lower band
The middle line of the indicator is a simple moving average (SMA).
Most charting programs default to a 20-period, which is fine for most traders, but you can experiment with different moving average lengths after you get a little experience applying Bollinger Bands.
The upper and lower bands, by default, represent two standard deviations above and below the middle line (moving average).
If you’re freaking out because you’re not familiar with standard deviations.
Have no fear.
The concept of standard deviation (SD) is just a measure of how spread out numbers are.
If the upper and lower bands are 1 standard deviation, this means that about 68% of price moves that have occurred recently are CONTAINED within these bands.
If the upper and lower bands are 2 standard deviations, this means that about 95% of price moves that have occurred recently are CONTAINED within these bands.
How this indicator works
- When the bands tighten during a period of low volatility, it raises the likelihood of a sharp price move in either direction. This may begin a trending move. Watch out for a false move in opposite direction which reverses before the proper trend begins.
- When the bands separate by an unusual large amount, volatility increases and any existing trend may be ending.
- Prices have a tendency to bounce within the bands’ envelope, touching one band then moving to the other band. You can use these swings 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 then becomes the profit target.
- Price can exceed or hug a band envelope for prolonged periods during strong trends. On divergence with a momentum oscillator, you may want to do additional research to determine if taking additional profits is appropriate for you.
- A strong trend continuation can be expected when the price moves out of the bands. However, if prices move immediately back inside the band, then the suggested strength is negated.
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