Bollinger Bands

Bollinger Bands are a type of trading “envelope” consisting of lines plotted above and below a moving average, which are designed to capture a market’s typical price fluctuations.

The indicator is similar in concept to the moving average envelope (see Indicator Insight, Active Trader September 2002, p. 84), with an important difference: While moving average envelopes plot lines a fixed percentage above and below the average (typically three percent above and below a 21-day simple moving average), Bollinger Bands use a statistical calculation called standard deviation to determine how far above and below the moving average the lines are placed. As a result, while the upper and lower lines of a moving average envelope always move in tandem, Bollinger Bands expand during periods of rising market volatility and contract during periods of decreasing market
volatility.

Bollinger Bands were created by John Bollinger, CFA, CMT, the president and founder of Bollinger Capital Management (see Active Trader, April 2003, p. 60).


Calculation

By default, the upper and lower Bollinger Bands are placed two standard deviations above and below a 20-period simple moving average.

Upper band = 20-period simple moving average + 2 standard deviations

Middle line = 20-period simple moving average of closing prices

Lower band = 20-period simple moving average – 2 standard deviations

Standard deviation is a statistical calculation that measures how far values range from an average value — in this case, how far prices stray from a 20-day moving average. Statistically, 95 percent of values will fall within two standard deviations of the average value, which means 95 percent of price action should occur within the upper and lower Bollinger Bands.



Interpretations and use

Bollinger Bands highlight when price has become high or low on a relative basis, which is signaled through the touch (or minor penetration) of the upper or lower line. Put another way, price is seen as relatively high (overbought) on a touch of the upper band and relatively low (oversold) on a touch of the lower band.

However, Bollinger stresses that price touching the lower or upper band does not constitute an automatic buy or sell signal. For example, a close (or multiple closes) above the upper band or below the lower band reflects stronger upside or downside momentum that is more likely to be a breakout (or trend) signal, rather than a reversal signal.

Accordingly, Bollinger suggests using the bands in conjunction with other trading tools that can supply context and signal confirmation.