Bollinger Bands

What is it?

Bollinger Bands is a volatility indicator that was developed by John Bollinger and is one of the most useful bands in technical analysis. Bollinger Bands consist of three lines – a simple moving average (SMA), and two lines calculated at a specified number of standard deviations above and below the SMA. The bands indicate overbought and oversold levels relative to a moving average and can used to confirm trading signals.

Standard deviation is a statistical function that measure the probable variation from the average or the mean. One standard deviation above and below the mean theoretically contains 68.2% of the variations from the mean while two standard deviations above and below the mean contain 95.4% and three standard deviations above and below the mean contain 99.6% of the variations from the mean.

During periods of volatility i.e., during increased price fluctuation, the upper and lower bands widen and when the price fluctuations decrease, the bands contract towards the price range. They can thus be used to compare volatility and relative price levels over a period of time.

How is it calculated?

Bollinger originally used a 20-period simple moving average (SMA) for the center band, a 20-period SMA plus 2 standard deviations for the upper band, and a 20-period SMA less 2 standard deviations for the lower band. The two outer bands should theoretically contain 95.4% of the price action.

How is it used?

Bollinger Bands is a popular indicator used in mean reversion trading systems. They do not give absolute buy and sell signals when prices reach the upper or lower bands, but indicate whether the price of the security is high or low relative to the price mean (or the SMA). It can also be used for a more informed confirmation of a trading signal when used with other technical indicators.

Contracting bands indicate a possible trend though the first breakout is often a false move, preceding a strong trend in the opposite direction.

A move that begins at one band normally carries through to the other band when the security is trading within a range.

For trend followers, a move outside the band indicates a strong trend is strong and likely to continue. However, mean reversiontraders see it as an indication that the price is high relative to the mean, and could reverse.

A close outside the band, followed by a close inside the band, indicates a trend reversal that is confirmed when the price moves across the center band.

Chart Example

The following chart shows the standard Bollinger Bands in orange on a 30-minute chart of the Dow Jones Industrial Index. The middle (dash) line is a 20-period SMA. Notice how the bands contract during periods of low volatility and expand during periods of high volatility.

DOW chart with Bolinger Bands
Bollinger Bands on a 30 Minute DOW chart

Wealth Warning

Trading equities, options, derivatives, currencies, commodities or any other financial security can offer significant returns BUT can also result in significant losses if the market moves against your position. It requires a strong commitment to skill development, knowledge acquisition, and emotional control. It should be treated as a business with a clear business plan, a risk analysis, and set of attainable goals. The risk associated with trading the vagaries of the stock markets is probably the most important consideration as it has a profound effect on emotional control. You should not trade the stock markets with money you cannot afford to lose as there is considerable exposure to risk in any stock market transaction.

Furthermore, the past success of any trading method, strategy, or system is only indicative of future success. Under no circumstances should past success be construed as a guarantee of future success!

Volatility Indicators

Relative Volatility Index

Volatility indicators, which measure the volatility of a security's price action, are important to day traders. When volatility increases, the price movements are more volatile and traders can gain more money in a short period of time. Some of the popular volatility indicators include J Wells Wilder's Average True Range, John Bollinger's Bollinger Bands, Chaikin's Volatility, and Relative Volatility Index (RVI).

The Chicago Board Options Exchange (CBOE) also provides a some volatility indicators, such as the S&P 500 Volatility Index (VIX), the S&P 100 Volatility ...

Trading Bands

Trading Bands
Trading Bands

Several indicators that are placed on the price chart and are based on Moving Averages can be used to form trading bands. These bands can be adjusted to contain most of the proce action with the price often moving between the two moving bands, touching one and then the other. These bands can be used to confirm trading signals, and can also indicate overbought and oversold levels. Some bands, such as the Bollinger Bands and the Keltner Channel have a middle line that can act as support or resistance.

The most popular bands are ...

Standard Deviation

Standard Deviation
Standard Deviation

Standard Deviation is used in statistics and probability theory and is represented by the Greek letter sigma (σ). It is calculated as the square root of variance. Variance is the average of the squared differences from the mean and is calculated by subtracting the mean from each value in the sample, squaring the result, and then dividing the sum of the results by one less than the total number of sample values.

A low standard deviation indicates that the sample values are close to the mean or the expected value, while a high standard deviation indicates that the sample values are widely spread above and below the mean.

Probability theory holds that 68.2% of all probable values will fall with in one standard deviation from the mean, 94.4% of all probable values will fall with in two standard deviations from the mean, and 99.7% of all probable values will fall with in three standard deviations from the mean.

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