Bollinger Bands Indicator
Bollinger bands were developed by a fellow named John Bollinger.
It is an indicator that allows stock traders to compare volatility and relative price levels over a period of time.
This indicator consists of three bands designed to encompass the majority of a stocks price action:
1. A simple moving average in the middle. The standard is a 20 day simple moving average (SMA).
2. An upper band (standard is 20 day simple moving average plus 2 standard deviations)
3. A lower band (standard is 20 day simple moving average minus 2 standard deviations)
Standard deviation is a statistical term that provides a good indication of volatility. Using the standard deviation ensures that the bands will react quickly to price movements and reflects periods of high and low volatility.
Sharp price increases or decreases, hence volatility, will lead to a widening of the bands.
For further in-depth information on the Bollinger Band indicator, this resource contains critical information to help you learn to use stock charts and technical indicators in a clear, simple and concise manner to improve your trade entries and exits.
Bollinger bands serve two primary functions:
- Identify periods when prices are at an extreme levels, and are ready to change, such as double tops and double bottoms
- Identify periods of high and low volatility
Double Bottoms and Tops
A double bottom buy signal is given when prices penetrate the lower band on the first of the double bottom, and remain above the lower band after the second bottom forms.
The bullish setup is confirmed when the price moves above the middle band, or 20 SMA.
As seen in the chart above, the stock penetrated the lower band in late February, and then stayed above it on the second bottom low in mid-March.
The breakout above the middle 20 SMA band provided the confirmed buy signal.
A double top would be the same, but reversed.
Volatility
Band width is also of value. Being able to identify a period of low volatility can serve as an alert to monitor the price action of a stock.
Sharp price changes can occur after the bands have tightened and volatility is low. It is the width of the bands expressed as a percent of the moving average.
When the bollinger bands narrow drastically, a sharp expansion in volatility usually occurs in the very near future. The price most often starts off in the wrong direction prior to really taking off.
The chart above is a classic example.
As with this indicator, it is meant to be used in conjunction with other indicators.
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