This technical analysis tool was created by John Bollinger back in the 1980's. With it you can see if the price is relatively low or high in comparison to previous trading prices. This indicator falls in the volatility categorie of indicators.
The Bollinger Bands indicator consists of three lines, that create a band on the chart:
The Moving Average, which is usually calculated as a 20-period Simple Moving Average.
The Upper Band, which is usually the Moving Average + two standard deviations.
The Lower Band, which is usually the Moving Average - two standard deviations.
As you can read, this is quite a simple indicator and it is even more easy to understand when you see it on a chart:
How to interpet the Bollinger Bands
The Bands can be used to get a sense of the relative high and low of the price. Price will mostly stay inbetween the Bollinger Bands, but it's relative position to the bands will determine a high of low price. Price is high when it is are near the Upper Band. This means the markte is overbought and in an uptrend. Price is low when price is close to the Lower Band. This means price is oversold and in a downtrend. And if the price breaks out of the bands it is highly likely it will return to the space inbetween the lines.
A higher volatility is indicated by the widening of the bands. This means that the price is moving away more from the Moving Average. A lower volatility period is indicated by the bands tightening and getting closer to the Moving Average line. The tightening can also be user to predict a coming period of higher volatility.
How to trade the Bollinger Bands
If the price falls below the Lower Bollinger Band, you get a buy signal.
Exit this position when the price reaches the moving average line.
A trader could short sell if the price rises outside the Upper Bollinger Band.
Look for these signals indicated on the following chart:
A more conservative less risky way of trading Bollinger Bands
The text above explains a very aggressive way of trading the Bollinger Bands. If you would like to use them for a more conservative approach to trading you should wait and only trade when the price returns back to the inside of the bands again. This will reduce risk and losses, but it will decrease the possible trade opportunities you get. Another way to use the Bands to reduce risk is to exit trades when the price reaches the Moving Average.
A Breakout is when the price has been within the well-defined pattern of the bands for a while (indecision) and close outside of them. It is recommended to use other indicators in tandem to decide when you want to buy or sell with the direction of the Breakout.
This is when price closes above the Upper Band after a time of staying inbetween the Bands. To confirm a breakout buy signal, you should use other indicators to reduce risk.
This is when price closes below the Lower Band after a time of staying inbetween the Bands. To confirm a breakout signal, you should use other indicators to reduce risk.