Bollinger Bands
Analysis:
Bollinger Bands were created by John Bollinger in the 1980's. They are a type of trading band whereby, the bands are drawn above and below a specified period simple moving average (see moving averages) at intervals determined by a multiple of standard deviation. John Bollinger suggests using a period of 20 for the moving average and plus & minus two standard deviations for the bands.
In layman's terms, the upper and lower bands are just curves which are drawn around the price movements. The middle band is a moving average which is drawn through the price movements. The upper and lower bands are generated using a standard deviation which measures the dispersal pattern of a set of data. Therefore, the more volatile a data set (price action) becomes, the wider apart the bands will become. This is because price action is moving around a lot, generating violent swings higher and lower therefore, dispersing the data significantly. During lower volatility the bands become tighter, generally during periods of consolidation. This might indicate future volatility is to come and, along with it, trading opportunities.
Bollinger Bands Use Cases
Bollinger Bands often act as support and resistance levels, with price rarely trading outside of the upper or lower bands. This is best demonstrated during the low volatility, consolidation phases. Therefore, a trader might sell when price touches the upper band and set profit targets at the middle band and lower band as price moves lower. The opposite would be true if price hits the lower band, triggering a buy order with profit targets at the middle and upper band. However, Bollinger Bands should not be used as the only indicator to determine a trade setup. Like all other indicators, it should be used in conjunction with multiple other reasons to enter a trade. With that being said, the exact opposite method might be used to assist with a trading strategy. In this instance, a trader might buy the market when price breaches the upper band and ride this breakout higher until price breaks below the middle band, indicating a fall in bullish momentum. This is why it is important not to rely on these indicators to act as one standalone system but instead to use them to increase the odds in your favour as to which way the market is likely to move. I have given two completely opposite examples of how to use these bands to increase your odds, it's up to the trader to decide which method (if any) will successfully integrate with their trading style and ultimately improve their trading.
Because the bands are based on moving averages and standard deviations of the data set (in this instance an asset's price), about 90% of all price action occurs within the bands. Therefore, a break of the bands can be considered a significant event. However, this alone is not enough to determine a trade setup or entry and Bollinger Bands should be used alongside other indicators or market analysis before considering entering a trade.
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