Bollinger Bands

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Bollinger Bands was developed by John Bollinger to compare volatility and relative price levels over a selected period of time. You plot the Bollinger Bands (BB) with price. It consists of three bands (moving averages) designed to cover the majority of a security's price action. Those three bands are:

1. In the middle - a simple moving average (SMA) of the closing price;
2. An upper band - an SMA that is in the middle plus n standard deviations (two standard deviations are normally used);
3.  A lower band - an SMA that is in the middle minus n standard deviations (two standard deviations are normally used).

The Standard deviation is used to measure a price plot's volatility. Applying the standard deviation to a simple moving average ensures that the upper and lower bands will react quickly to price movements, taking into account periods of high and low volatility. For intermediate timeframes, Bollinger advises the use of a 20-bar simple moving average for the center band and two standard deviations for the upper and lower bands. For shorter-term timeframes, a 10-bar simple moving average can be used, whereas a 50-day simple moving average is recommended for longer-term timeframes.

As an example, Bollinger Bands (20, 3, 2) would draw a 20-bar simple moving average, an upper band the same as SMA (20) plus three standard deviations and a lower band as SMA (20) less two standard deviations.

The Bollinger Bands were designed to identify periods of high and low volatility and to define periods when prices are at extreme, and possibly unsustainable, levels. An ability to identify volatility helps to adapt a trading system to generate signals in time and not too late or too early. At the same time, changes in the volatility may prompt you to monitor the stock (security) for a possible change in the trend. In this case, other technical indicators can be useful and help to recognize a potential reversal.

As a rule, stocks (securities) go through periods of high volatility and low volatility. Historically, sharp changes in price trend can occur when volatility is low. Bollinger Bands allow you to visually identify these periods: tight bands indicate low volatility and wide bands indicate high volatility. Volatility can be important for options players, as well, because an option price depends on the volatility of the underlying security and the lower the volatility of a stock is, the cheaper is an option on that stock.

In addition to volatility analysis, Bollinger Bands may be used in junction with other indicators to predict significant moves. "Double Bottom Buy" and "Double Top Sell" are commonly used techniques in technical analysis to predict Buy and Sell points.

Double bottom Buy: A Double Bottom Buy signal is given when prices penetrate the lower band and remain above the lower band after a subsequent low has formed. Either low can be higher or lower than the other. The important thing is that the second low remains above the lower band. The bullish setup is confirmed when the price moves above the middle band, or simple moving average.

Double Top Sell: A Double Top Sell signal is given when prices peak above the upper band and a subsequent peak fails to break above the upper band. The bearish setup is confirmed when prices decline below the middle band.

Chart 1: NASDAQ 100 - Bollinger Bands

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