Again, this indicator consists of three bands encompassing a security’s price action. Defaults are:
1. A simple moving average in the middle, usually 20 days for intermediate investing.
2. An upper band ( 20 day SMA plus 2 standard deviations)
3. A lower band (20 day SMA minus 2 standard deviations)
Standard deviation is a statistical term that provides a good indication of volatility. Using it
ensures the bands will react quickly to price movements and reflect periods of high and low
volatility. Sharp price changes and hence volatility, will lead to a widening of the bands.
Closing prices are usually used to compute Bollinger Bands. Other variations can also be used.
The length of the moving average and number of deviations can be adjusted to better suit
individual preferences and specific characteristics of a security.
One method to determine an appropriate moving average length is a visual assessment. Bollinger
Bands should encompass the majority of price action, but not all. After sharp moves, penetration
of the bands is normal. If prices appear to penetrate the outer bands too often, then a longer
moving average may be required. If prices rarely touch the outer bands, then a shorter moving
average may be required.
A more exact method to determine moving average length is by matching it with a reaction low
after a bottom. For a bottom to form and a downtrend to reverse, a security needs to form a low
that is higher than the previous low. Properly set Bollinger Bands should hold support
established by the second (higher) low. If the second low penetrates the lower band, then the
moving average is too short. If the second low remains above the lower band, then the moving
average is too long. The same logic can be applied to peaks and reaction rallies. The upper band
should mark resistance for the first reaction rally after a peak.
In addition to identifying relative price levels and volatility, Bollinger Bands can be combined
with price action and other indicators to generate signals and foreshadow significant moves:
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 forms. 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 simple moving average.
Double top sell: A 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.
Sharp price changes can occur after the bands have tightened and volatility is low. In this
instance, Bollinger Bands do not give any hint as to the future direction of prices. Direction must
be determined using other indicators and aspects of technical analysis. Many securities go
through periods of high volatility followed by periods of low volatility. Using Bollinger Bands,
these periods can be easily identified with a visual assessment. Tight bands indicate low
volatility and wide bands indicate high volatility.