Bollinger bands

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In the 1980s, John Bollinger, a long-time technician of the markets, developed the technique of using a moving average with two trading bands above and below it. Unlike a percentage calculation from a normal moving average, Bollinger Bands simply add and subtract a standard deviation calculation.

Standard deviation is a mathematical formula that measures volatility, showing how the stock price can vary from its true value. By measuring price volatility, Bollinger Bands adjust themselves to market conditions. This is what makes them so handy for traders: they can find almost all of the price data needed between the two bands. Read on to find out how this indicator works, and how you can apply it to your trading.(For more on volatility, see Tips For Investors In Volatile Markets.)

What’s a Bollinger Band®?

Bollinger Bands consist of a center line and two price channels (bands) above and below it. The center line is an exponential moving average; the price channels are the standard deviations of the stock being studied. The bands will expand and contract as the price action of an issue becomes volatile (expansion) or becomes bound into a tight trading pattern (contraction). (Learn about the difference between simple and exponential moving averages by checking out Moving Averages: What Are They?)

A particular security may stay in a trade positions for long periods in a trend. To understand the trend better, traders use the moving average to filter the price action. This way, traders can gather important information about how the market is trading. For example, after a sharp rise or fall in the trend, the market may consolidate, trading in a narrow fashion and criss-crossing above and below the moving average. To better monitor this behaviour, traders use the price channels, which encompass the trading activity around the trend.

Markets have vicissitudes daily even though they are still trading in an uptrend or downtrend. Technicians use moving averages with support and resistance lines to anticipate the price action of a stock. Upper resistance and lower support lines are first drawn and then extrapolated to form channels within which the trader expects prices to be contained. Some traders draw straight lines connecting either tops or bottoms of prices to identify the upper or lower price extremes, respectively, and then add parallel lines to define the channel within which the prices should move. As long as prices do not move out of this channel, the trader can be reasonably confident that prices are moving as expected.