A Bollinger Band® is a set of lines plotted two standard deviations (positively and negatively) away from a simple moving average of the security’s price. A Bollinger Band®, developed by famous technical trader John Bollinger, is normally plotted two standard deviations away from a simple moving average but can be adjusted to user preferences.
The squeeze is the central concept of Bollinger Bands®. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities. Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or which direction price could move.
Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event. The breakout is not a trading signal. The mistake most people make believes that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.
Bollinger Bands® are not a standalone trading system. They are simply one indicator designed to provide traders with information regarding price volatility. John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals. He believes it is crucial to use indicators based on different types of data. Some of his favoured technical techniques are moving average divergence/convergence (MACD), on-balance volume and relative strength index (RSI).
The bottom line is that Bollinger Bands® are designed to discover opportunities that give investors a higher probability of success.
How to interpret Bollinger Bands
- Overbought signal
When a price is near the upper band, it might be considered overbought, potentially indicating a price correction could be coming. - Oversold signal
When a price is near the lower band, it might be considered oversold, potentially signaling a price rebound. - Breakout potential
If the price breaks through the upper or lower band, it could signal a potential trend change. - Not a standalone indicator
Bollinger Bands should be used in conjunction with other technical indicators and fundamental analysis to make informed trading decisions. - Customization
Traders can adjust the time frame and standard deviation used to calculate the bands to suit their trading style. - Volatility impact
Market conditions with high volatility will result in wider bands, while low volatility will result in narrower bands.