The invention of the Bollinger Bands (BB) belongs to the American analyst John Bollinger, who in 1984 set out to create his own technical indicator for making trading decisions. Bollinger launched his Bollinger Bands to the investment and trading community in the early 90s. The technical indicator gained popularity among market participants, was adopted by many traders, and is still used today.
The three bands
The indicator consists of three bands (lines): the Simple Moving Average (SMA) in the middle and an upper and lower band in between. The idea behind Bollinger Bands is to combine a trend indicator, a volatility indicator, and an oscillator into one. The bands in between adjust their width as price changes, widening when the market is volatile and narrowing during more stable periods. Thus, the Bollinger Bands act as oscillators, where the upper band indicates overbought when the price touches it, and the lower indicates oversold.
How BB is calculated
The upper and lower bands are shifted by two standard deviations from middle band. The standard deviation is a common way to measure volatility or how far data (price) deviate from the mean (the SMA). It is calculated from the data points of the SMA. Then the result is subtracted from the SMA to get the value of the lower band and added to get the value of the upper band.
Two standard deviations capture 95% of the price action or data points. If the price travels outside the band, it should renter and eventually revert to the simple moving average or middle line. A three standard deviation captures a 97.7% percentage of data making the price less likely to move outside the band boundary. As the deviation increase, a trading signal becomes rare as the price will need to be extremely overbought and oversold, and this would be a rare occurrence.
Bollinger recommends using a 20-period (N) SMA as the middle line and 2-standard deviations to calculate the band boundaries. Traders can use other periods (13 to 23) and standard deviations (2 to 5). The higher the period, the lower the sensitivity of the indicator to price movement.
How to interpret the Bollinger Bands
John Bollinger explains in his book Bollinger on Bollinger Bands that his indicator is not intended for continuous price movement analysis. However, the indicator gives signals that, by themselves or in conjunction with other methods of analysis, allow you to use good trading opportunities with high-profit potential.
Traders should not use the same period on all timeframes and assets. As practice shows, each asset and timeframe has its own optimal period. But it should be understood that the higher the period of the indicator, the greater the lagging factor and the less sensitive the indicator to price fluctuations.
In addition, the readings of the BB indicator cannot be read straightforwardly as a point-to-point rebound, otherwise, you will get a large number of false signals. The indicator is best used in conjunction with other indicators such as the MACD.
A correctly chosen period of the indicator helps to turn the middle line of the indicator into a dynamic support/resistance level with a directional price movement. Breakdown and consolidation behind this line will mean a stop or a trend reversal.
If the upper band diverges from the mean, this indicates a continuation of the current trend, and if it converges closer to the mean, this may indicate a weakening trend and a possible reversal.
The position of the price relative to the middle line indicates the direction of the trend. If the price is above it, this indicates an upward trend and vice versa.
If the bands narrow, volatility drops in the market. If they expand, volatility increases. The longer the range is in a narrow corridor, the stronger and further the price will move.
If the price touches the upper band, the asset is currently considered overvalued, and if the price reaches the lower band, the asset is seen as undervalued.
The Bollinger Bands is a technical indicator that measures price volatility relative to its moving average. It provides good trading signals by identifying low and high prices as they come close to the lower and upper bands respectively.