Once a trader of stocks, commodities, or Forex decides to place and manage trades based on technical analysis rather than fundamental analysis, other means are required to determine what trades should be made. “Price Envelopes” are one available category of indicators. One type of price envelope is Bollinger Bands.
What do Bollinger Bands Measure?
Bollinger Bands were created in the 1980s by John Bollinger with the intention of being an improvement over simple price envelopes. The Bollinger Bands are moving averages plotted based on the standard deviation from the moving average of the price of the item. The closing price is used to calculate a moving average, which is plotted as the center band. Outer bands are plotted some number of standard deviation from the moving average.
Typical settings for Bollinger Bands that have worked well for traders is to use a 20-day moving average for the centerline and two standard deviations for the outer bands from it. Experience has shown that this will provide a good balance of tracking normal price swings and expanding and contracting volatility.
How do Bollinger Bands Differ From Simple Price Envelopes?
Simple price envelopes consist of two moving average lines, one shifted upward and one shifted downward from the actual moving average. The intention of price envelopes is to show the normal trading range of a stock (or other item being traded). Normal practice is to plot the two lines the same distance from the actual moving average, say 10% above and 10% below. Any period of moving average can be used, and the percent displacement of the bands can be adjusted.
Bollinger bands, unlike the simple price envelope, plot the upper and lower bands at some standard deviation away from the actual moving average. Traders who watch Bollinger Bands will be able to recognize the changes in volatility as it is developing. To do so, however, requires experience and study of the Bollinger Bands.
How Are Bollinger Bands Used in Trading?
Professional traders use Bollinger Bands as an indication that a stock is over-bought or over-sold; in other words, that a price run of a certain amount—either up or down—has been so great that a reversal in the short-term price trend is most likely to occur. This is mostly because major buying institutions, such as mutual funds, hedge funds, and endowment funds make buying/selling decisions due to the recent price changes that result in a price reversal.
However, professional traders usually don’t use Bollinger Bands as a stand-alone indicator, but rather to confirm what other indicators are showing, or as a first suggestion that a price reversal is about to occur and that other indicators should be checked.
References:
Steven B. Achelis, Technical Analysis from A to Z, pages 71-74; 2001, McGraw-Hill
Martin J. Pring, Technical Analysis Explained, pages 174-177; 2002, McGraw-Hill
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