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.
