Bollinger Bands were created by market technician John Bollinger. They are a branch of envelope analysis and use standard deviations in calculation instead of a fixed percentage. Bollinger Bands are displayed as three bands (see Figure 1). The middle band normally consists of a moving average of 20 days. The upper band is derived by adding two standard deviations to the middle band. The lower band is found by subtracting two standard deviations from the middle band.
FIGURE 1: SAMPLE CHART WITH BOLLINGER BANDS
Bollinger placed the upper and lower bands at a distance of two standard deviations to better correct for market volatility. For instance, in moving average envelopes, where the user would find the upper and lower bands by adding a fixed 3% (or any other arbitrarily fixed percentage), the adjustments made for periods of extreme ups and downs would be inadequate. By letting the variance of the Bollinger Bands be correlated with the standard deviation of the moving average, the bands would be more adaptable to market changes; the Bollinger Bands are far better at containing prices. Because the middle band is sandwiched between the upper and lower bands, this formation is referred to an envelope.
Bollinger Bands can encompass a wider range of price movement, and so they are especially useful for determining when a stock is overbought or oversold. When the price is at or above the upper band, the stock may be overbought. If, however, the price is at or below the lower band, the stock may be oversold. John Bollinger observed about his Bollinger Bands:
- Sharp price changes tend to occur after the bands tighten, as volatility lessens.
- When prices move outside the bands, a continuation of the current trend is implied.
- Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for a reversal of trend.
- A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.
To confirm your own observations about Bollinger Bands, John Bollinger suggests that you use his indicator in conjunction with the relative strength index (RSI). Bollinger Bands can be computed automatically on MetaStock and CompuTrac programs.