The indicator was created by a Mr John Bollinger in the 1980s as a method for traders to visually identify extreme prices and volatility within a security.
HOW ARE THEY CONSTRUCTED?
The indicator is created by plotting a SIMPLE MOVING AVERAGE (normally - 20 periods) along with 2 “VOLATILITY” BANDS above and below.
The outer bands are created by simply adding and subtracting, typically 2 standard deviations, from the 20 day simple moving average.
Standard deviations are used to create this indicator because they are a common measure of volatility in statistics.
BUT, WHAT IS STANDARD DEVIATION?
Basically standard deviations measure how far away you are from the average or how prices are dispersed around an average price value.
The moving average is just that, the average price value over the last number of periods and the use of 2 standard deviations from the average is typically used because it tends to incorporate at least 95% of all prices within those 2 bands. That is what you want.
However, if the market being traded is particularly volatile the trader may wish to use a setting of 2.5 or even 3 standard deviations instead.
Likewise, if the security isn’t volatile at all, the trader may wish to use a setting of 1 standard deviation. You are looking for extreme prices with the Bollinger bands, therefore you want at least 95% of prices to fall between the 2 bands.
HOW BOLLINGERS ARE USED?
Broadly speaking they are used in 1 of 2 ways:
Looking for contractions and expansions of volatility.
Finding short-term extreme prices where the outer bands are pierced.
1. CONTRACTIONS & EXPANSIONS
Since Bollingers reflect volatility, the bands around the average move and fluctuate as volatility changes.
- When volatility drops the bands will get tighter which is called a CONTRACTION.
- When volatility increases, the bands will move apart from each other called an EXPANSION.
One of the main concepts to understand when using Bollinger bands, is that periods of LOW VOLATILITY tend to be FOLLOWED by periods of HIGH VOLATILITY and vice versa. In other words, if the trader starts to notice the bands contracting and pinching together, then there is a reasonable chance that volatility will increase and that a trading opportunity or breakout may soon appear.
2. THE PIERCING OF THE OUTER BANDS
Another method of using Bollinger bands, is to note when the price of a security moves beyond and pierces the upper or lower band.
If prices have pierced the upper band, they can generally be considered “expensive” or “overbought” since prices are more than 2 standard deviations above the average price.
BUT BE CAREFUL, just because it's "overbought", this doesn’t mean you should immediately trade in the opposite direction. Prices can often run along the band for quite some time.
Conversely, if prices have pierced below the lower band, they can be thought of as "oversold" since they are more than 2 standard deviations below the average price.
Identifying prices that move beyond the bands help traders take advantage of unjustifiably high or lower prices.
For higher success with your trades you’ll need a few other confirming factors to come together:
- Look to long the lower band only in an uptrend (and vice versa)
- Look for candlestick patterns that show signs of reversal.
- Ensure the piercing of outer bands coincides with support and resistance