Bollinger Bands
Bollinger Bands were created in the 80’s by John Bollinger. John Bollinger was the first who had the idea of drawing bands with variable width, depending on the standard deviation of the price. Standard deviation is a measure of volatility.
In this way, the bands react to price movements and reflect periods of high and low volatility. Fast price increases or decreases, and hence volatility, will lead to a wider band, whereas more quiet periods in price action will lead to a narrower band.
Bollinger Bands consist of three curves that encompass the majority of a security's price action. As a standard, the 20-period moving average is used. A bandwidth of 2 standard deviations is also typical.
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Middle curve = 20-day Moving Average
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Upper band = Middle band + 2 standard deviations
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Lower band = Middle band - 2 standard deviations
John Bollinger himself prefers to use the 20-period Simple Moving Average as a middle curve, whereas the Upper and the Lower Bands will be two 20-period standard deviations above and below the middle curve respectively. Of course we can use different values on all three variables: The moving average, the number of standard deviations, and the number of periods used for the calculation of standard deviations.
The Figure below shows the Bollinger Bands – the black curves. The middle dotted line is the 20-period Moving Average and the two other curves are the upper and the lower bands that are two standard deviations above and below the moving average. As we can see, the price action is mostly confined within the upper and the lower band.
Fig. 1: The Bollinger Bands are the black lines. The dotted line in the middle is the 20-day Moving Average. Price stays mostly within the upper and the lower Bollinger Band.
INTERPRETATION OF BOLLIGNER BANDS
Bollinger Bands help us find trends
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In a trend, the price stays close to the outer band. As long as price touches and goes along the outer band, the trend is strong.
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When price starts to pull away from the outer band we should be cautious, as momentum starts to weaken.
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When price reaches the moving average in the middle and bounces back to its original direction the trend is quite strong.
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In cases of range movement, the outer Bollinger Bands can act as support and resistance.
Let’s take each of the above points and expand it a bit:
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In a trend, the price stays close to the outer band. As long as price touches and goes along the outer band, the trend is strong.
Let’s look at the chart below:
Fig. 2: In a strong uptrend price moves in the upper Band, between the 20- period moving average and the upper Bollinger Band.
We have marked two regions with a blue and an orange box. In both cases, the price stays above its 20- day moving average and just below the upper Bollinger Band. This kind of regime is an indication that buying remains intense as the bulls are strong and push prices higher.
In the case the 20 period moving average acts as support. Whenever price touches the middle band, it bounces up pushed by the strong bulls. When this uptrend develops both Bands are moving up.
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2. When price starts to pull away from the outer band we should be cautious, as momentum starts to weaken.
Let’s have a look at the blue boxes in the following chart.
Fig. 3: Momentum starts to weaken when the price pulls away from the outer Bands.
In the first box, price pulled away from the upper Band and moved closer to the 20-period moving average. Nothing could tell us which direction price would take, until a huge bearish candlestick pushed the price to the lower Band.
In the second box, price moved away from the lower Bollinger Band and after a minor pullback it moved fast above its 20- day exponential moving average and on the upper Bollinger Band. In both cases above, the price reversed after it moved away from the Bollinger Band.
The third box has a different development. Price pulls away from the upper Bollinger Band and moved toward the 20- day exponential moving average, but before that, it turns up and reaches the upper Bollinger Band again. In this case price resumed its uptrend.
3. When price reaches the moving average in the middle and bounces back to its original direction the trend is quite strong.
Below we can see a typical example.
Fig. 4: Price reaches its 20- day exponential moving average and bounces off to its original direction
In the blue box, the tails of the price candlesticks touched the 20- day exponential moving average three times. In fact, the long lower tails of the candlesticks also indicate that the bulls are strong enough to keep price moving up.
4. In cases of range movement, the outer Bollinger Bands can act as support and resistance.
In the above chart, the price moved in a range before starting its uptrend. While in the range the lower and the upper Bollinger Bands acted as Support and Resistance lines respectively.