In the 1980s, well-known technical trader John Bollinger developed an analysis tool that provides better chances of determining whether prices are high or low on a relative basis.
Traders would use these charts to aid them in their decision making, to control automated trading system, or as tools for technical analysis. It is even used outside of finance as it is applied to manufacturing data to spot flaws in printed textile.
What is this chart called? The Bollinger Band® — trademarked in 2011 by the creator himself.
Bollinger Bands are a type of price envelope, which define the standard deviation levels below and above the Simple Moving Average of the price. The charts use Period and Standard Deviations as their parameters, with 20 being the default value for Period and 2 for Standard Deviations.
This is how the Bollinger Bands look like. They wrap the 20-day SMA of the asset with a lower and upper band along the price movements. When the band expands as the market’s volatility increases, It could also signal a possible trend reversal.When the bands narrow during a low volatility period, this is known as a squeeze. Traders see this as a potential sign of impending high volatility and trading opportunities.
Prices often bounce within the brackets. These swings can be used to identify possible profit targets. When the price bounces off the lower band and then goes above the moving average, the upper band becomes the profit target.
The prices can also exceed or hug a band envelope for a long period of time during an uptrend.
You may also use a momentum oscillator — such as the Relative Strength Index or RSI — to check for any divergence or convergence. In this case, you can see a convergence indicating a trend confirmation.
When the price exceeds one of the bands, a strong trend continuation is highly possible. However, if the prices go back into the envelope, it is suggested that the strength might be negated.
One thing to keep in mind is that a breakout — which refers to a major event when the price breaks out of the bands — does not actually provide a proper buy or sell signal. This is because breakouts don’t tell you about the trajectory and the length of future price movement.
Much like most of the previous technical indicators, Bollinger Bands are not meant to be used alone. John Bollinger himself suggests using them with two or three other indicators that provide direct trading signals. He especially favours the MACD or Moving Average Divergence/Convergence and the RSI techniques.
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