Bollinger Bands make use of moving averages to produce trading signals based on market volatility. Devised by John Bollinger, they are among the simplest technical indicators to use.
A 20-day simple moving average of the security is plotted. Above and below these are the bands, which are two standard deviations away from the moving average.
You don’t need to know about standard deviations to understand the indicator; suffice to say that this methodology ensures around 95% of all price action remains within the two bands.
The most obvious way to look at Bollinger Bands is as an indicator of whether prices are overextended. Generally, you would say that as prices reach and move beyond the upper and lower bands the market is becoming respectively overbought or oversold.
However, it is worth noting that as prices touch bands they are as likely to continue to move beyond the bands as they are to move back within the range.
You can use the bands for signals. For example, if a reversal pattern on the price chart – such as a double top, head and shoulders, double bottom – occurs at the extreme of the band, it can be a stronger signal than if it occurs in the middle of the bands.
For example, a double top with a first top beyond the upper band limit, with the second top forming below the upper band, may be considered a fairly strong signal that the market is about to reverse.
Bollinger Bands tend to widen as volatility increases and narrow when volatility recedes. Usually, you can expect a sharp move in the price of the security when the bands tighten.
But while a narrowing of the bands foreshadows a big move, it is unclear from the indicator in which direction you can expect this move to occur.
Therefore it is useful to use this in conjunction with other technical tools, such as momentum indicators, chart patterns, candlestick formations, etc.
Bollinger Bands are useful in determining specific price targets. This is because prices have a tendency to swing from one extreme to the other.
Therefore if the security’s price touches the upper band, a reasonable price target would constitute the lower band level.
However, as with oversold and overbought indicators, it is worth noting that prices are as likely to continue to move beyond the bands as they are to retrace back between the two bands.
Indeed, according to John Bollinger, when markets move outside the bands, a close outside the bands act as continuation signals, not reversal signals.