Bollinger Bands are an indicator that adapt to the market action to define what "too high" and "too low" mean.
Many indicators use arbitrary levels to define high and low values. For example, the Relative Strength Index (RSI) is considered oversold when it falls below 30 and overbought above 70. These static values fail to consider the market action and, in reality, an oversold market can become even more oversold. Arbitrary signal levels limit the usefulness of any technical indicator.
Bollinger Bands adapt to the most recent market activity and move higher and lower along with the market. Overbought and oversold levels then reflect the reality of what is happening in the market now rather than being defined by an expert based on experiences from several decades ago.
Bollinger Bands can be applied to price or to any indicator, and they can be found for any time frame. They are calculated using the standard deviation of recent data.
Using daily prices as an example, the first step would be to find the 20-day moving average of the closing prices. The standard deviation of that average would then be calculated. Default settings are to add 2 standard deviations to the average for the upper Band and subtract 2 standard deviations from the average to find the lower Band.
When price is oversold, it will fall to the lower Band and often break below it. Overbought markets will see prices rise to the upper Band and above. The distance between the Bands will expand and contract with the market action, making this technical indicator a useful way to define volatility.
How Traders Use It
Bollinger Bands could be used as a complete trading strategy. Traders can buy when the price rises back above the lower Band after closing below that level. Selling would be done when prices fall below the upper Band after closing above it. This simple strategy identified several winning trades in the chart below.
The chart of the PHLX Housing Sector index also shows how the Bands contract and expand, and that cycle of contracting and expanding plays out continuously in the markets.
The Bands narrow when prices are in a trading range, and that is an indication to traders that volatility is likely to expand soon. Trading the most volatile stocks allows traders to seek the greatest profits in the shortest amount of time.
Why It Matters To Traders
Bollinger Bands adapt to the market. Traditional momentum indicators could signal that a market is oversold shortly after a powerful uptrend begins, and the indicator may continue to show that the market is oversold until well after the trend has reversed. Bollinger Bands are more adaptive and would offer a more reliable timing tool.
Bollinger Bands also offer a way to visualize volatility. Many traders believe that volatility is more cyclical than price, i.e., periods of low volatility are followed by periods of high volatility and vice versa. When they see the width of the Bands begin to expand, traders can expect increased volatility in the price to follow, and this helps identify the best trading candidates.
Other indicators, like Moving Average Convergence/Divergence (MACD), could be combined with Bollinger Bands to determine the most likely direction of the expected breakout.
(This article originally appeared on ProfitableTrading.com.)