How to Read Bollinger Bands
What are Bollinger Bands?
Developed by John Bollinger, Bollinger Bands are a technical analysis tool that consists of two bands
placed around a 20-day moving average. The upper band is calculated as the 20-day moving average
plus two standard deviations, while the lower band is the 20-day moving average minus two standard
deviations.
Formula:
- Upper Band: 20-day MA + 2 standard deviations
- Lower Band: 20-day MA – 2 standard deviations
Standard Deviation is a statistical measure that describes how prices are distributed around the
average value. Using two standard deviations ensures that 95% of the price data falls between the
bands.
Key Points:
- Bollinger Bands measure market volatility.
- When volatility increases, the bands widen; during quiet periods, the bands contract.
- Prices near the upper band suggest an overbought market, while prices near the lower band
suggest an oversold market. - The bands can also serve as price targets.
Structure:
- Middle Band: An N-period simple moving average (MA)
- Upper Band: MA + K times an N-period standard deviation
- Lower Band: MA – K times an N-period standard deviation
Typical values for N (number of periods) and K (multiplier for standard deviation) are 20 and 2,
respectively.
Bollinger Bands help determine whether prices are high or low relative to previous trades, and they
are used to assess market conditions and potential price targets.
Averages Used: The default choice for the average is a simple moving average, but other types, such
as exponential moving averages, can be used as needed. Typically, the same period is used for both
the middle band and the standard deviation calculation.
Purpose: Bollinger Bands provide a relative definition of high and low prices. By design, prices are
considered high at the upper band and low at the lower band. This helps with pattern recognition and
is useful for comparing price action with indicator action to make systematic trading decisions.
Interpretation: Traders use Bollinger Bands in various ways. Some buy when the price touches the
lower band and sell when it reaches the moving average in the centre. Others buy when the price
breaks above the upper band or sell when it drops below the lower band.
- Low Volatility: Bands close together indicate low volatility.
- High Volatility: Bands far apart indicate high volatility.
- Channel: Bands that are parallel for an extended period suggest that the price will oscillate
between them.
Traders often combine Bollinger Bands with other indicators, such as chart patterns or trendlines, for
confirmation. This combination strengthens the evidence for the forecasts provided by Bollinger
Bands.