Bollinger bands are an indicator created by John Bollinger in the 1980s whose main purpose is to measure the volatility of the studied asset, or the percentage of deviation from the average price of the stock, combining it with the trends of the moving averages.
The author himself defined this indicator as a simple Technical Analysis tool and not a complete trading system.
Let’s take an example: if a financial instrument records a volatility of 7% in a given period, this means that, in the period under study, the value of the asset has deviated on average by 7% from its average price, be it up or down.
Volatility therefore identifies how much the price of a nightclub stock from the average price in a given period; combining this data with the current trend, the best trading opportunities can be outlined.
“These bands are a mere technical analysis tool and not a complete trading system”
cit. John Bollinger
Bollinger bands are presented with a graph consisting of three lines. Two trading bands within which the price structure of the studied financial instrument develops, and a central line, the moving average.
The moving average used is usually the 20-period one, while the two outer bands are set at a value of 2 standard deviation both above and below the moving average.
The use of 2 standard deviations allows you to have a 95% certainty that the price data will be included within the two trading bands.
Standard deviation measures the amount of variability or dispersion around the mean and is a measure of volatility.
Bollinger bands are designed with the intention of creating an instrument capable of giving traders the opportunity to identify whether the financial instrument studied is in the oversold or overbought phase.
The upper band is considered as a resistance line and the lower band as a dynamic support line and in practice, when prices reach these lines, it is an overbought or oversold zone.
Relevant factor is the distance between the bands: if the bands are contracted and are close to each other, the market is going through a moment of low volatility, a phase often anticipating the start of a new directional movement. Conversely, when the bands get too far apart, we are in a situation of high volatility and often coincides with the current trend of the market being exhausted.
If we are in the first situation where we see the bands contracting, it is possible to take advantage of the moment by placing a breakout order. That is, if the candles break the upper band, with probabilistic calculation the price will continue to rise. Conversely, if the candles break the lower band, the probabilistic price will continue to descend.
In the second situation, with the lines of the bands expanding, it is important to note that when the price comes close to the upper overbought band and crosses it and promptly re-enters the band, with probabilistic calculation we are faced with a bearish reversal of the trend. Similarly, if the price arrives close to the lower band, exceeding it and promptly returns within the band, with probabilistic calculation we are faced with a bullish trend reversal.
In both cases, the price target can be positioned on the central 20-period average.
Bollinger Bands can be used as price targets. If prices bounce on the lower band and cross upwards with the 20-period average, the upper band becomes the upper price target.
Similarly, if prices bounce on the upper band and intersect downwards with the 20-period average, the lower band becomes the target for the lower price.
If we are in a strong trending situation, prices fluctuate between the upper and middle band or between the lower and average band. In this case, a downward or upward crossing of the average would mean a possible trend reversal.