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Home » » Bollinger Bands Indicator: Explanation and Function

Bollinger Bands Indicator: Explanation and Function

What Are Bollinger Bands?

Bollinger Bands are a technical analysis tool created by John Bollinger in the 1980s. This indicator is a derivative of Moving Averages (MA), extended with two additional lines: the Upper Band and the Lower Band. These two lines act as price boundaries, with more than 90% of price movements occurring within them.

The standard recommended parameters are a 20-period MA with 2 Standard Deviations (2SD):

  • Upper Band: MA-20 + 2SD
  • Lower Band: MA-20 - 2SD

Standard Deviation measures price volatility, which is the difference between the closing price and the average value. The higher the Standard Deviation, the wider the distance between the Upper and Lower Bands, indicating higher volatility. Conversely, the lower the Standard Deviation, the closer the two bands are, signaling lower volatility.

Functions of the Bollinger Bands Indicator

1. Detecting Overbought and Oversold Conditions

  • Overbought: When the price moves outside the Upper Band, it signals an overbought condition, meaning the price may have risen too quickly and could soon decline.
  • Oversold: When the price dips below the Lower Band, it indicates an oversold condition, suggesting that the price might have dropped too sharply and could potentially rebound soon.

A buy signal occurs when the price is oversold, while a sell signal occurs when the price is overbought.

2. Indicating Strong Trends

  • Strong Trend: If the price stays in the upper half of the Bollinger Bands, the MA-20 (middle line) acts as support. This suggests a robust upward trend in the market. Conversely, if the price stays in the lower half, it suggests a strong downtrend.

3. Identifying Breakouts

  • Buy Signal: When the price breaks above the Upper Band, accompanied by a breakout from resistance, especially after a consolidation phase (sideways movement) and a Bollinger Bands squeeze (narrowing).
  • Sell Signal: When the price breaks below the Lower Band, accompanied by a break of support after a consolidation phase and narrowing of the Bollinger Bands.

4. W-Bottoms Signal

Steps:

  1. A downtrend is signaled when the lowest level falls below the Lower Band.
  2. A rebound breaks through the Middle Band.
  3. A second dip occurs with a lower low than the first point but stays above the Lower Band.
  4. The price breaks above the high from the second point's rebound.

5. M-Tops Signal

Steps:

  1. An uptrend occurs with the highest level above the Upper Band.
  2. A correction follows, breaking below the Middle Band.
  3. A second rise occurs with a higher high than the first point but remains below the Upper Band.
  4. The price breaks below the low from the second point's correction.

Bollinger Bands are a valuable tool in technical analysis, helping traders identify overbought and oversold conditions, indicate strong trends, identify breakouts, and provide signals for W-Bottom and M-Top patterns. By understanding and applying Bollinger Bands correctly, you can enhance your trading decisions and strategies.

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