Bollinger Bands are a technical analysis tool used to analyse volatility of a security. Bollinger helps in identifying the overbought and oversold levels. These Bands can be used on most financial instruments like equities, indices, foreign exchange, commodities, futures, options and bonds.
They are curves drawn in and around the price structure on chart. It primarily consist of a simple moving average (also known as the middle band), an upper band, and a lower band. This bands helps in knowing whether prices are high or low on a relative basis.
This curves when drawn on a chart helps in taking buy or sell signals. Whenever the price touches the upper band a sell can be triggered. On the other hand when price touches lower band a fresh buying position can be started.
Bollinger bands are calculated by assembling this 3 elements given below :
- Middle line usually a 20 day simple moving average of the closing prices.
- Upper band – this is plotted +2 standard deviation above the middle line
- A lower band – this is plotted -2 standard deviation below the middle line
Trading Strategy Points To Remember :
- Closer the prices move to the upper band, more overbought the market.
- closer the prices move to the lower band, more oversold the market.
- Buying when stock prices cross below the lower Bollinger Band.
- Selling when stock prices cross above the bollinger band.
- It is useful in trending as well as non-trending market.
- The upper and lower bands act as a trigger to open a trade.
- Breakout above or below the bands is a crucial event.
- The breakout is not a trading signal.
- However a new trend towards up or down indicating a strong momentum.
- Wider the bands greater is the volatility.
- Narrow bands reflects low volatility hence sideways movements.
- Bollinger Bands are not meant to be used as a stand-alone tool.
- Analyst should combine Bollinger Bands with basic trend analysis and other indicators for confirmation. Like MACD ,EMA ,RSI etc.