Bollinger Bands (BB)

Bollinger Bands (BB) is a widely used technical indicator developed by John Bollinger that assists in assessing whether prices are relatively high or low. Created in the early 1980s by trader, analyst, and educator John Bollinger, this indicator addresses the need to visualize volatility changes.

Traders typically utilize Bollinger Bands to identify overbought and oversold conditions, confirm divergences between prices and indicators, and set price targets. The indicator consists of three lines plotted in relation to price movements:

• Upper Band
• Middle Line
• Lower Band

The middle line is generally a Simple Moving Average (SMA) calculated over a 20-day period, which serves as the foundation for the Upper and Lower Bands. These bands measure volatility by examining the relationship between the bands and the price. Usually, the Upper and Lower Bands are set at two standard deviations from the SMA, although traders can adjust these settings as needed. As volatility rises, the bands widen; conversely, they narrow when volatility decreases.

Period (20) – This refers to the number of bars or periods used for the calculation. John Bollinger suggests an optimal period of 20 or 21 and cautions that periods shorter than ten may not yield effective results.

Band Width (2) – This represents the half-width of the band in terms of standard deviations, with “2” being the typical value used.

To calculate Bollinger Bands, first determine the simple moving average. Then, calculate the standard deviation (SD) over the same number of periods as the SMA. For the upper band, add the standard deviation to the SMA, and for the lower band, subtract the standard deviation from the SMA.

Typical values include:

• Short term: 10-period moving average, bands at 1.5 standard deviations.
• Medium-term: 20-period moving average, bands at 2 standard deviations.
• Long term: 50-period moving average, bands at 2.5 standard deviations.

When the bands contract during low volatility, it increases the likelihood of a significant price movement in either direction, potentially initiating a trend. However, be cautious of false moves that may reverse before the actual trend begins. Conversely, when the bands widen significantly, it indicates increased volatility, suggesting that an existing trend may be concluding.

Prices often oscillate within the bands, touching one band before moving to the other. These fluctuations can help identify potential profit targets. For instance, if the price rebounds off the lower band and crosses above the moving average, the upper band becomes the target for profit.

During strong trends, prices may exceed or closely follow a band for extended periods. If there is divergence with a momentum oscillator, further investigation may be warranted to decide if taking additional profits is suitable. A strong trend continuation is likely when the price moves outside the bands; however, if it quickly returns inside, the anticipated strength is negated.

Traders commonly use Bollinger Bands to identify overbought and oversold conditions, confirm divergences between prices and indicators, and set price targets. Wider bands indicate greater volatility, while narrower bands suggest lesser volatility. Some traders combine Bollinger Bands with other technical indicators, such as the RSI.

If the price touches the Upper Band and the accompanying technical indicator does not confirm the upward movement (indicating divergence), a sell signal is generated. Conversely, if the indicator confirms the upward movement, no sell signal is issued, and a buy signal may be indicated.

Similarly, if the price touches the Lower Band and the other technical indicator does not confirm the downward movement, a buy signal is generated. If the indicator confirms the downward movement, no buy signal is issued, and a sell signal may be indicated.

Another strategy involves using Bollinger Bands independently. In this method, a chart peak above the Upper Band followed by a peak below it generates a sell signal, while a chart trough below the Lower Band followed by a trough above it generates a buy signal.

Bollinger Bands also assist in identifying overbought and oversold markets. When prices approach the upper band, the currency pair is becoming overbought, while prices nearing the lower band indicate an oversold condition. Price momentum should also be considered; when a price enters an overbought or oversold area, it may become even more extreme before reversing. Always look for signs of price weakening or strengthening before anticipating a trend reversal.

Bollinger Bands differ from similar indicators like Keltner Channels or Moving Average Envelopes in that their range width is not constant but varies with historical volatility. An increase in volatility results in wider bands, while a decrease leads to narrower bands. A significant widening of the bands may signal the end of a trend, while a notable narrowing suggests the beginning of a new trend.

Bollinger Bands consist of a Middle band (SMA) and Upper and Lower Bands based on Standard Deviation (SD), which contract and expand with volatility. They are a valuable tool for analyzing trend strength and monitoring potential reversals. However, Bollinger Bands are not predictive; they rely on historical data and respond to price changes without anticipating them.

Like other indicators, Bollinger Bands are most effective when used alongside additional indicators, price analysis, and risk management as part of a comprehensive trading strategy.