Bollinger Bands, also known as BB or Bollinger Lines, is a tool used for technical analysis. It has features found in both trend indicators and oscillators. It can be used to determine a possible range of the asset price changes based on the nature of the asset’s volatility and movement.
Description
Bollinger Bands indicators display lines on the price chart of an asset, which show the limits of the price dynamics below and above respectively. One of its uses is to dynamically show the lines of resistance and support, which are situated relatively far from the current price most of the time.
Bollinger Bands appear like an envelope of moving averages. The envelope’s lines are situated below and above the moving average curve at fixed distances, which are expressed as percentages. Bollinger Bands limits are shown at these distances, which are equal to a specified number of standard deviations.
As the volatility of the asset’s price will determine the magnitude of the standard deviation, the width of the bands is automatically adjusted. The width decreases when the price is relatively stable and will increase when there is more volatility.
Constructing Bollinger Bands
Bollinger Bands are constructed using the following guidelines: the price of the asset should fall outside the Bollinger Band lines about 5% of the time, while it should be inside the lines 95% of the time when using 2 standard deviations for the calculation. The indicator consists of three lines.
- The bottom line forms the lower band, and it is normally two standard deviations below the moving average.
- The top line forms the upper band and it is normally two standard deviations above the moving average.
- The center line shows a simple moving average, which is set to a period of 20 by default, although other periods may be used.
Bollinger Bands’ ranges are unique in that their width changes depending on the volatility in the market. Although a Bollinger band is created as a band surrounding a simple moving average, its width is proportional to the standard deviation from the moving average for the period that is being analyzed.
The band will become narrow when the market is flat, and it will expand when the market becomes volatile, e.g. when news is released.
Tips & Tricks
It is recommended that Bollinger Bands be used in conjunction with other tools, the same as other indicators. The objective of using this indicator is to identify any extreme deviations of the asset’s average rate in the current trend.
If you select the indicator settings correctly, the moving average (the center line) is a good indication of resistance and support levels, and the Bollinger Band channel limits can be used as targets to open positions.
The areas of overestimated and underestimated prices should be watched. When this happens, as soon as a price moves outside the Bollinger channel, it will move back immediately. John Bollinger noted that if an asset’s price goes higher than the upper price, the asset is overvalued, and if it moves lower than the lower band, the asset is undervalued. Based on the efficiency theory, the market will react to deviations very quickly and the price will be returned to its fair price zone.