What is Bollinger Bands indicator?
Bollinger Bands are a technical analysis tool widely used by traders to identify with greater probability when an asset is oversold or overbought.
Bollinger Bands are a technical analysis tool widely used by traders to identify with greater probability when an asset is oversold or overbought.
The Bollinger Bands consist of 3 trend lines, a simple moving average (SMA) which is the middle band and two standard deviations arranged positively and negatively to the simple moving average which are respectively the upper and lower bands.
How to use it ?
Broadly speaking, the closer the stock price is to the upper band, the higher the probability that the market is overbought, and respectively the closer the stock price is to the lower band, the higher the probability that the market is oversold.
On the chart above we can see that the Bollinger Bands (upper band and lower band) frame the SMA. The standard deviation being a measure of volatility, the more the Bollinger bands deviate from the SMA the higher the volatility of the price and conversely the closer the Bollinger bands are to the SMA the lower the volatility of the price.
The squeeze is the main concept of the Bollinger Bands, which is when the two bands are close to each other, tightening the SMA. When a squeeze occurs it signifies a period of low volatility and can be a sign of future high price volatility and therefore trading opportunities. Conversely, when the Bollinger Bands are far apart, it signifies a period of high volatility and may be a sign that volatility is about to decrease and therefore a potential trade exit.
On average the price lies 90% of the time between the two Bollinger bands around the SMA. Any breakout above or below the bands signifies a major event that may mean a period of over buying or over selling.
It is important to note that the Bollinger Bands are only used to give information about the volatility of the price. They do not provide trading signals on their own. It is advisable to use them with 2 or 3 other uncorrelated technical indicators.
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The formula of Bollinger Bands:
BOLU = MA(TP,n) + m[TP,n]
BOLD = MA(TP,n) + m[TP,n]
Where:
BOLU = Upper Bollinger Band
BOLD = Lower Bollinger Band
MA = Moving Average
TP=typical price=(High +Low+Close) 3
n = Number of days in smoothing period (typically 20)
m= Number of standard deviations (typically 2)
[TP,n]= Standard Deviation over last n periods of TP