Bollinger Bands (“Bollinger Lines”, or BB) is a technical analysis tool that has the features of both a trend indicator and an oscillator. It determines a possible range of the asset price change according to the nature of its movement and volatility.
The Bollinger Bands indicator consists of the lines on the asset price chart, which limit the price dynamics above and below respectively. This is a kind of dynamic lines of support and resistance, which most of the time are placed quite far from the price.
“Bollinger Bands” look like the envelopes of moving averages. The difference between them is that the lines of the envelopes are located above and below the moving average curve at a fixed distance expressed as a percentage. And the limits of Bollinger Bands are constructed at the distances, which are equal to a certain number of standard deviations.
Since the magnitude of the standard deviation depends on the volatility, the bands’ width is adjusted automatically. It increases when there is an uptrend and decreases in more stable periods.
The main rule for the construction of Bollinger Bands is the following: about 5% of the price should be outside these lines, and 95% of it should be inside (when calculating for 2 standard deviations). The indicator is formed by three lines.
- The middle line is a simple moving average (a 20-period one by default).
- The top line is the upper band that is usually two standard deviations above the moving average.
- The bottom line is the lower band, which is usually two standard deviations below the moving average.
The unique feature of Bollinger Bands’ ranges is that their width changes in response to a change in the market volatility. A separate Bollinger band is constructed as a band around the simple moving average, but its width is proportional to the standard deviation from the moving average for the analyzed period.
The band expands when the market is volatile, for example, during the news release. And it narrows when the market is flat.
Just like other indicators, we recommend you use Bollinger Bands together with other tools. The aim of this indicator is to determine sharp deviations from the average rate of the current trend of the currency pair.
If the settings of the indicator are selected correctly, the moving average (the central line) itself is a good level of support / resistance, and the limits of the Bollinger Bands channel may be used as targets when one opens positions.
Pay attention to the areas of underestimated and overestimated prices. As soon as the price leaves the Bollinger channel, it immediately gets back.
John Bollinger himself said that if the price goes beyond the lower band, the asset is undervalued, and if it goes above the upper price, the asset is overvalued. According to the efficiency theory, the market reacts to deviations quickly and returns the price to its relatively fair price zone.
We will tell you about the professional customization of the Bollinger Bands indicator in our next article. Follow our updates!