Developed by John Bollinger, Bollinger Bands are volatility bands placed above and below a moving average. Volatility is based on the standard deviation, which changes as volatility increases and decreases. The bands automatically widen when volatility increases and narrow when volatility decreases. Bollinger Bands are similar to moving average envelopes. The difference between Bollinger Bands and envelopes is envelopes are plotted at a fixed percentage above and below a moving average, whereas Bollinger Bands are plotted at standard deviation levels above and below a moving average. Bollinger bands are drawn within and surrounding the price structure of a trading instrument. It provides relative boundaries of highs and lows.
Bollinger Bands are displayed as three bands. The middle band is a normal moving average mostly 20 period moving average and is known as trend indicator. The upper and lower bands are then a measure of volatility to the upside and downside. They are calculated as two standard deviations from the middle band.
Upper Band = Middle band + 2 standard deviations
Middle Band = 20 period moving average (most charting packages use the simple moving average)
Lower Band = Middle band – 2 standard deviations.
The below chart shows the upper and lower bands for Bollinger bands.
The bands were at their widest when prices were volatile during August 2015. They narrowed when prices entered a consolidation period later during March-June. The narrowing of the bands increases the probability of a sharp breakout /breakdown in prices. The longer prices remain within the narrow bands the more likely a price breakout.
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.
In Next Article we will discuss
Bollinger Band Trading Strategies
- Bollinger Bands to identify tops and bottoms
- Trend Following