Bollinger bands are an indicator of volatility, used by traders to identify areas of support and resistance and areas in which an asset could experience increased or decreased volatility. Bollinger bands are calculated from three lines drawn on a price chart.
The first is the simple moving average (SMA) of the price of an asset over a given period – usually 20 days. The upper band is the SMA plus two standard deviations that have been multiplied by two, while the lower band is the SMA minus two standard deviations that have been multiplied by two.
The exact method for calculating the different Bollinger Bands is as follows:
- The upper band = 20-day SMA + (20-day standard deviation multiplied by 2)
- The lower band = 20-day SMA – (20-day standard deviation multiplied by 2)
- The SMA is calculated by summing the closing prices in a fixed period and dividing that number by the total number of periods.
Many retailers use it Bollinger bands to indicate areas of market volatility – and they assume that the more the bands deviate from the SMA, the more volatile the underlying market is. In contrast, if the bands are narrow, then many traders take this to show that the underlying market price is stable.
When the bands widen, traders call it a Bollinger bounce and believe it is indicative of an upcoming rebuke. Narrow bands are known as Bollinger pressure and this is taken to indicate an upcoming break in the underlying asset.
Bollinger bands are a late indicator that some consider a disadvantage. This means that they seek to confirm trends rather than predict future market movements. Indicators that aim to predict future market movements are known as leading indicators, and these include the relative strength index (RSI) or the stochastic oscillator.
However, late indicators like Bollinger bands can be used to confirm a trend before entering a position, although this is most effectively done in conjunction with other technical indicators. This means that a trader could miss the start of a trend, but they still profit after they have used a late indicator, or a collection of late indicators, to confirm the trend.
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