What is the Bollinger Bands Technique?
This indicator was developed by John Bollinger and is explained in detail in his opus called Bollinger on Bollinger Bands. The technique involves overlaying three bands (lines) on top of an OHLC bar chart (or a candlestick chart) of the underlying security.
The central band is a simple arithmetic moving average of the daily closes using a trader-selected moving average index. The upper and lower bands are the running standard deviation above and below the central moving average. Since the standard deviation is a measure of volatility, the bands are self-adjusting, widening during volatile markets and contracting during calmer periods.
[caption id="attachment_13116" align="aligncenter" width="550"] Bollinger Bands[/caption]
Bollinger bands require two trader-selected input variables: the number of days in the moving average index and the number of standard deviations to plot above and below the moving average. More than 95 percent of all daily closes fall within three standard deviations from the mean of the time series. Typical values for the second parameter range from 1.5 to 2.5 standard deviations.
As with moving average envelopes, the basic interpretation of Bollinger bands is that prices tend to stay within the upper and lower bands. The distinctive characteristic of Bollinger bands is that the spacing between the bands varies based on the volatility of the prices. During periods of extreme price changes (that is, high volatility), the bands widen to become more forgiving. During periods of stagnant pricing (that is, low volatility), the bands narrow to contain prices.
Bollinger notes the following characteristics of Bollinger bands:
- Sharp price changes tend to occur after the bands tighten, as volatility lessens.
- When prices move outside the bands, a continuation of the current trend is implied.
- Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
- A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.