Bollinger Bands
tl;dr
Bollinger Bands are a tool used to measure volatility and identify potential overbought or oversold conditions. The bands consist of a middle moving average and two outer bands that expand and contract based on market volatility. Traders watch for the price to touch or break through the bands to signal potential reversals or trends, confirming with other indicators for better accuracy.
Definition.
A volatility indicator consisting of a moving average and two standard deviation lines.
Real-World Example.
Bollinger Bands are a popular technical analysis tool used by traders to measure market volatility and identify potential overbought or oversold conditions. They consist of three lines:
- The middle band, which is typically a simple moving average (SMA) of the asset’s price (usually set to 20 periods).
- The upper band, which is the middle band plus two standard deviations.
- The lower band, which is the middle band minus two standard deviations.
For example, let’s say you’re tracking a stock, and its Bollinger Bands are set to a 20-period moving average with a 2-standard deviation. When the price moves closer to the upper band, it could indicate the stock is overbought and might reverse. If the price approaches the lower band, it could signal that the stock is oversold and may be due for a bounce.
How to Use Bollinger Bands.
- Identify Volatility: Bollinger Bands expand and contract based on market volatility. When the bands widen, it signals high volatility, and when they tighten, it signals low volatility. Traders often watch for periods of contraction (narrow bands) followed by a breakout in either direction.
- Overbought and Oversold Conditions:
- Upper Band: When the price reaches or exceeds the upper band, it could signal that the asset is overbought, suggesting a potential reversal or price pullback.
- Lower Band: When the price drops to or below the lower band, it could indicate that the asset is oversold, suggesting that the price may reverse upward or consolidate.
- Bollinger Band Bounce: A common strategy is to buy when the price touches the lower band and shows signs of bouncing back, or sell when the price touches the upper band and starts to pull back. However, this should be confirmed with other indicators like RSI or MACD to improve accuracy.
- Breakouts and Continuation: If the price breaks out above the upper band or below the lower band, it could signal the start of a new trend. For example, a breakout above the upper band could indicate a strong upward move, while a breakout below the lower band might signal a downward trend.
- Using with Other Indicators: Bollinger Bands work best when combined with other technical analysis tools. For example, if the price is near the lower band and the RSI is showing oversold conditions, it may be a stronger signal for a potential bounce. Similarly, if the price is near the upper band and the RSI shows overbought conditions, it may suggest a reversal.
