Bollinger Bands
Bollinger Bands are a technical analysis tool developed by John Bollinger in the 1980s. They consist of three lines plotted on a price chart, representing the volatility and potential price movement of a financial instrument, such as a stock, currency pair, or commodity.
Here's the breakdown of the components and how Bollinger
Bands are calculated:
Middle Band (Simple Moving
Average - SMA): The middle line is usually a
20-period simple moving average (SMA) of the asset's price. It serves as the
baseline or centreline for the Bollinger Bands.
Upper Band: The upper band is calculated by
adding a specified number of standard deviations (usually 2) above the
20-period SMA. The formula is: Upper Band = 20-period SMA + (2 x Standard
Deviation of Price)
Lower Band: Similarly, the lower band is
derived by subtracting the same number of standard deviations (usually 2) from
the 20-period SMA. The formula is: Lower Band = 20-period SMA - (2 x Standard
Deviation of Price)
The standard deviation measures the volatility of the asset's
price. Widening of the Bollinger Bands indicates increased volatility, while
narrowing bands suggest decreased volatility.
Example:
Let's consider a stock with a 20-day Bollinger Bands setup.
Middle Band: 20-day SMA
Upper Band: 20-day SMA + (2 x 20-day standard deviation)
Lower Band: 20-day SMA - (2 x 20-day standard deviation)
Suppose the stock's 20-day SMA is $100, and the standard
deviation is $5.
Upper Band: $100 + (2 x $5) = $110
Lower Band: $100 - (2 x $5) = $90
In this case, the Bollinger Bands for the stock would be $110
(upper band) and $90 (lower band) around the 20-day SMA of $100. These bands
provide a visual representation of the potential price range based on
volatility.
Traders often use Bollinger Bands to identify potential
overbought or oversold conditions. When the price touches or exceeds the upper
band, it might indicate the asset is overbought. Conversely, when the price
touches or goes below the lower band, it could suggest an oversold condition.
However, these signals should be used in conjunction with other technical
indicators or analysis for more reliable trading decisions.
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