The main purpose of Bollinger Bands® is to help traders determine whether assets are reasonably priced, and whether prices in the market are stable or may be moving toward different levels. This information can be potentially helpful for investors because it can determine the following: whether they are paying a fair price for the asset, whether it is too costly, or whether it is a bargain purchase that could result in profit in the future.
Bollinger Bands® are not recommended as an exclusive method for understanding price movements. However, they are considered an effective tool for analysing price movements among several other tools. Those include basic trend analysis and indicators such as stochastics, moving average convergence and divergence, wave patterns and price gaps.
Bollinger Bands® were developed by John Bollinger in 1983, and they're a system under a registered trademark.
The measurement system for the bands is based on price volatility. The "bands" are lines traced on a chart as averages and outer limits for prices. Within the system there are three lines—an upper line, a lower line and a middle line. The middle line is based on a moving average of price. In outlining his method, Mr. Bollinger recommended the use of 20-day moving price averages for analysis.
The upper and lower band lines are based on a standard deviation of the price from the moving average. Standard deviation is a mathematical measurement for how spread out a group of numbers is on average. In the case of Bollinger Bands®, the numbers involved are prices.
On most analysis systems, traders can change the periods, and thus the standard deviation, used in the calculation of the bands according to their preferences for trading time horizons.
The region between the upper and lower bands is often referred to as an "envelope."
Using Bollinger Bands®
A price trend that remains narrow and in the direction of either the upper or lower band line is considered to be a strong trend.
Analysts pay particular attention to when prices are trending near the upper or lower bands. Prices that are near the upper band are considered to be "overbought," and good prospects for selling. Similarly, prices that are near the lower band are considered to be "oversold," and good prospects for buying.
Signals: Trading Tops And Bottoms
The Bollinger analysis system uses visual patterns to determine when the market has reached a high or low price. Some of the main "signals" for price trends are patterns that come in the shapes of the letters "W" for market price bottoms and "M" for tops. When a price of a given asset reaches a low on the chart, chartists look for repetition of that low at the second bottom on a "W" shape for confirmation that the price will not likely go lower.
The middle price peak before the second downward trend on the "W" pattern is understood to be the "breakout" point. If the price rebounds above this point following the second low of the "W" shape, then the price is understood to have broken out of the downward trend and initiated a trend on a new upward movement.
The same type of analysis holds for determining the top of a price trend, only in an inverted manner. If an upward movement falls from a peak, analysts look for a second repetition of the peak in an "M" shape. When the price falls to below the middle "breakout" point in a second downward movement on the "M" shape, the price is determined to be on a new downward trend.
The fact that a price breaks beyond the upper or lower Bollinger Band® is not necessarily considered a "signal" of a possible new price movement. Analysts note that prices can frequently trend along the lines and break out on occasion When this occurs, the movement is called a "tag," and it is considered to indicate that a price is at a high or low within a shorter term price trend. However, it has been seen that frequently when a price breaks the upper or lower band, it will fall back within the band toward the mid-line.
Bollinger Bands® are also used for examining the potential volatility of the market. In particular, when the band "envelope" narrows significantly, it is considered to be a sign that volatility will soon increase. This can be helpful in cueing investors that buying or selling opportunities may be approaching.
In addition to using Bollinger Bands® as a tool on their own, they are frequently used with other indicators such as momentum, volume, sentiment, open interest and inter-market data.
One particularly popular indicator for use with the Bollinger Bands® is the Relative Strength Index (RSI), a "momentum oscillator" developed by J. Welles Wilder Jr. The RSI is used to compare upward movements in closing prices to downward movements over a selected period of time. Like other charting techniques, this index can be used to find signals that could determine bull market trends, bear market trends, trend reversals and large price corrections.
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