Created by John Bollinger in the 1980’s, Bollinger Bands have become a very well-known and widely used tool in technical analysis. It basically is a trading indicator denoted by three lines, to measure market volatility and identify areas of the market where the asset is overbought and oversold.
Bollinger Bands work closely with standard deviation, which shows how great the current market data has deviated from the average market data over a particular timeframe. As earlier stated, Bollinger Bands comprise three lines namely;
- Upper Band: This is the line that adds a standard deviation value of 2 to the middle band average. It is especially valuable in determining where the market has been over-bought.
- Middle Band: The middle band is perhaps the most important of the bands. It is a 20- period moving average that denotes the average market data for that period. It gives the two outer bands their functionality.
- Lower Band: This is the opposite of the Upper Band. It adds a standard deviation of 2 to the Middle Band, particularly looking to spot where the market has been oversold.
The standard deviation value need not be 2, but 2 is the default setting. It can be adjusted to suit market peculiarities and trader preferences. The same applies to the moving average (Middle Band).
Simply, the outer bands widen with a price increase, and they contract with a price decrease. This widening and contracting reveal market volatility. When volatility is low, the bands contract and they widen with high volatility. Conventionally, breakouts occur after a period of low volatility, with the length of the breakout period proportional to the length of the period of low volatility. The breakout tends to follow the current market trend, although it is more advisable to use indicators to confirm the breakout direction.
Candlesticks going beyond the upper band regularly in an uptrending market, or at least crosses above the moving average, indicates the increasing or sustained strength of the trend. This signifies that the asset is expensive, and is in a good area to sell if indicators point towards a coming downtrend.
Similarly, in a market that is trending down, a lot of price activity happens around the lower band. The more the activity pattern moves above the lower bands, the lesser the downtrend’s momentum gets. The asset here is relatively cheap, and could be a good position to accumulate if a breakout is on the horizon. A sharp reversal in a trend (a pullback from an outer band), and a subsequent return to that band signifies a lot of strength in the trend, be it an uptrend or a downtrend.
It is noteworthy that an asset coming across as cheap or expensive does not mean a trader should buy or sell. It is very important to know the incoming market sentiment before taking action. A cheap asset could plunge even lower after a trader buys into the market, resulting in losses. Selling an expensive asset without confirming an incoming downward spiral in prices could also reduce profits to be made in a trade. Bollinger Bands are lagging indicators, which means their analysis are reactive, they come after market action without necessarily predicting market activity. Thus, it is best used in conjunction with leading indicators for even greater results.
