Bollinger Bands, widely used technical analysis tool for assessing financial instrument volatility.
With this article we are wedging into Bollinger Bands, a key tool for gauging financial instrument volatility, using a middle band (20-day SMA), upper band (20-day SMA + 2 standard deviations), and lower band (20-day SMA - 2 standard deviations). Wider bands mean higher volatility. Touching or crossing bands can signal overbought or oversold conditions, hinting at a reversal. Bands also confirm trends, aiding traders in decision-making when combined with other indicators.
What are Bollinger Bands?
Bollinger Bands are a popular technical analysis indicator that traders and investors use to analyze the volatility and possible price swings of a financial instrument. They were created by John Bollinger in the 1980s and have three essential elements:
Middle Band (Simple Moving Average): The middle band represents a simple moving average (SMA) of the asset's price over a specified period, typically 20 days. It serves as the centerline of the Bollinger Bands and represents the asset's trend.
Middle band = 20-day SMA.
Upper Band: The upper band is formed by adding a specified number of standard deviations (usually twice) to the middle band. It represents the upper range of expected price movement and serves as a resistance level.
Upper band = 20-day SMA + (20-day SD x 2)
Lower Band: The lower band is calculated by subtracting the same number of standard deviations from the middle band. It represents the lower range of expected price movement and serves as a support level.
Lower band = 20-day SMA – (20-day SD x 2)
Bollinger Bands should be used in tandem with other technical analysis methods because they are not flawless. They are an excellent tool for determining price volatility and potential market turning points, supporting traders in making more informed judgments.
Volatility Assessment: Wide bands signify high volatility, whereas tight bands denote low volatility. This knowledge can be used by traders to decide on their trading strategies.
Price Reversal Indication: Prices touching or breaking through one of the bands can indicate probable overbought (close to the upper band) or oversold (close to the lower band) situations, which could come before a price reversal.
Trend Confirmation: Bollinger Bands are a useful tool for trend confirmation. Prices that cling to the top band during an uptrend or the lower band during a decline consistently point to a solid trend.
Trading Signals: Some traders integrate Bollinger Bands with other indicators to provide buy or sell signals. For instance, a move below the lower band may be a buy indication, and a move above the upper band may be a sell signal.