30 Apr 2019
Understanding Bollinger Bands and Their Uses
Bollinger Bands® are a type of technical analysis tool that is plotted on a statistical chart. They show the volatility and prices associated with a commodity or a financial instrument over a period of time. This tool was developed and copyrighted by famous technical trader, John Bollinger, in the 1980s. Today, numerous participants of the financial markets, including forex traders, use them to conduct sound technical analysis and make informed trading decisions. Given that currency traders are always on the lookout for incremental moves to enter positions, identifying a change in the trend and volatility becomes extremely important. Both these aspects can be analysed with the help of Bollinger Bands®. Here’s what you should know about this indicator.
How are They Calculated?Bollinger Bands® consist of three main lines or bands, the upper, middle and the lower band. The upper and lower bands are two standard deviation values (usually from a 20-day simple moving average), and the middle band is the simple moving average. The lines follow the concept of a volatility channel. To calculate the three bands, follow the steps below:
- First, find the simple moving average (SMA) of the financial instrument, commodity or currency you are interested in. Typically, a 20-day moving average is computed, since it can average out the closing prices of a currency for its first 20 days. This acts as the first data point on the chart. The successive data point will drop the earliest price, add the price of the 21st day, and then calculate the average. This process is repeated for every data point.
- Next, calculate the standard deviation of the currency under consideration. In a general sense, standard deviation is a quantitative measure of the average variance and is popularly used in statistics, accounting, finance and economics. You can calculate it by finding out the square root of variance, which in turn, is the average of the squared differences of the mean.
- After this, multiply the standard deviation value by two and add this new value to each data point present on the SMA line. This will give you the upper band. For the lower band, subtract the new value from each data point.
What Do Bollinger Bands® Indicate?Bollinger Bands® have become a popular tool due to the various signals they offer traders. A number of traders believe that the greater the proximity of prices to the upper band, the more overbought the market, and greater the proximity to the lower band, the more oversold the market. Apart from this, there are other specific indications that can be derived from Bollinger Bands®, such as:
- Reversal or continuation of trends
- Periods of potential market consolidation
- Upcoming periods of large volatility breakouts
- Possibility of market tops, bottoms and estimated price targets