Primary Functions

Again, although Bollinger Bands can help generate buy and sell signals, they are not designed to

determine the future direction of a security. The bands were designed to augment other analysis

techniques and indicators. By themselves, Bollinger Bands serve two primary functions:

 

  • To identify periods of high and low volatility
  • To identify periods when prices are at extreme, and possibly unsustainable, levels.

 

As stated above, securities can fluctuate between periods of high volatility and low volatility.

Being able to identify a period of low volatility can serve as an alert to monitor the price action

of a security. Other aspects of technical analysis, such as momentum, moving averages and

retracements, can then be employed to help determine the direction of the potential breakout.

 

Remember, buy and sell signals are not given when prices reach the upper or lower bands. Such

levels merely indicate that prices are high or low on a relative basis. A security can become

overbought or oversold for an extended period of time. Knowing whether prices are high or low

on a relative basis enhances interpretation of other indicators and timing issues in trading.

 

Bollinger Bands are a pair of values placed as an “envelope” around a data field. The values are

calculated by taking the moving average of the data for the given period and adding or

subtracting the specified number of standard deviations for the same period from the moving

average. Since Bollinger Bands use a moving average, the value at the beginning of a data series

is not defined until there are enough values to fill the given period. Used to confirm trading

signals, normally from a Momentum Indicator, the bands indicate overbought and oversold levels

relative to a moving average.

 

The bands are calculated at specified standard deviations above and below the moving average,

causing them to widen when prices are volatile and contract when prices are stable.

 

Bollinger Bands are useful for determining whether current values of a data field are behaving

normally or breaking out in a new direction. For example, when the closing price of a security

increases above its upper Bollinger Band, it will typically increase in that direction.

 

Bollinger Bands can also be used for identifying when trend reversals may occur. New highs or

lows outside of the bands followed by another high/low inside of the bands typically indicates a

reversal in the current trend.

 

Since the standard deviation can be used as a volatility indicator, the current width of the

envelope can also be used for trend information. A wide envelope indicates a high amount of

volatility, while a narrow envelope indicates a lower amount. High volatility levels can

sometimes be used to time trend reversals, such as market tops and bottoms. Low volatility levels

can sometimes be used to time the beginning of new upward price trends following periods of

consolidation.

 

Another observable trait of Bollinger Bands is that moves that begin at one band tend to go all

the way to the other band. This can be useful for forecasting future values. Bollinger Bands are

similar to Trading Bands and share many of their characteristics. However, unlike Bollinger

Bands, Trading Bands do not vary in width based on volatility.

 

Leave a Reply

You must be logged in to post a comment.