Bollinger Bands, invented by John Bollinger in the 1980s are a technical analysis tool. Bollinger Bands, having evolved from the concept of trading bands, can be used to measure the highness or lowness of the price relative to previous trades.
The main purpose of Bollinger Bands is to provide a relative definition of high and low. By definition, prices are high at the upper band and low at the lower band. This can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions.
The use of Bollinger Bands varies widely among traders. Some traders have the tendency to buy when price touches the lower Bollinger Band and exit when price touches the moving average in the center of the bands. Other traders buy when price breaks above the upper Bollinger Band or sell when price falls below the lower Bollinger Band. Moreover, the use of Bollinger Bands is not confined to stock traders; options traders, most notably implied volatility traders, often sell options when Bollinger Bands are historically far apart or buy options when the Bollinger Bands are historically close together, in both instances, expecting volatility to revert back towards the average historical volatility level for the stock.
A period of low volatility in stock price is indicated when the bands lie close together. Though, when they are far apart a period of high volatility in price is indicated. When the bands have only a slight slope and lie approximately parallel for an extended time the price of a stock will be found to oscillate up and down between the bands as though in a channel.
Bollinger Bands consist of:
- a middle band being an N-period simple moving average (MA)
- an upper band at K times an N-period standard deviation above the middle band (MA+K*sigma)
- a lower band at K times an N-period standard deviation below the middle band (MA-K*sigma)
Typical values for N and K are 20 and 2, respectively. The default choice for the average is a simple moving average, but other types of averages can be employed as needed. Exponential moving averages are a common second choice. Usually the same period is used for both the middle band and the calculation of standard deviation