An Introduction to Bollinger Bands
What is Bollinger Bands
Bollinger Bands was developed in 1980s by John Bollinger, a well-known technical analyst as a method for traders to identify extreme short-term prices in security. It is a technical analysis indicator that consists of 3 lines: the middle line is a 20-day moving average while the upper and lower lines are both standard deviation calculations. Standard deviation is used because it measures volatility hence it shows how a financial instrument price can vary from its true value.
The Purpose of Bollinger Bands
Bollinger Bands provides a relative definition of high and low. Prices are high at the upper band and low at the lower band. This definition helps technical traders make more systematic trading decisions by comparing price action to the actions of indicators and try to forecast price movements.
Interpreting the Bollinger Bands
The basic interpretation of Bollinger Bands is that prices tend to stay within the bands as the spacing between bands will adjust itself based on the current market volatility. When the price movement is highly volatile, the spacing between the bands will be widening while in low volatility conditions, the spacing will be narrowing.
If the narrow condition stays for a long period of time, the market is consider a sideway market and is expected to have a strong breakout either on upside or downside when the band widen again.
Another interpretation of Bollinger Bands is when the price moves outside the upper band, it is considered “overbought”, a sign for profit taking. When the price drops below the lower band, it is considered “oversold”, triggering a buy signal.
Bollinger Bands has become traders’ tool of choice because it helps them to identify prices that move beyond the bands. As it is important for traders to monitor shifts in volatility, this will help traders to take advantage of unjustifiably high or low prices.
Wan Zuraiha Wan Zakaria is a staff writer at Oriental Pacific Futures (OPF) where she writes on investment and trading. OPF is a futures and options broker based in Kuala Lumpur, Malaysia and provides electronic trading, brokerage and clearing services to retail and institutional traders since 2007. OPF is licensed under the Securities Commissions of Malaysia and offers cash-settled derivatives instruments traded on Bursa Malaysia, as well as select major derivatives exchanges around the world.
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