Bollinger Opens in a new window. (Price envelopes define upper and lower price range levels.) Bollinger Bands are envelopes plotted at a standard deviation level above and below a simple moving average of the price. Because the distance of the bands is based on standard deviation, they adjust to volatility swings in the underlying price.
Bollinger Bands use 2 parameters, Period and Standard Deviations, Steve. The default values are 20 for period, and 2 for standard deviations, although you may customize the combinations.
Bollinger bands help determine whether prices are high or low on a relative basis. They are used in pairs, both upper and lower bands and in conjunction with a moving average. Further, the pair of bands is not intended to be used on its own. Use the pair to confirm signals given with other indicators.
Calculation of Bollinger Band
First, calculate a simple moving average. Next, calculate the standard deviation over the same number of periods as the simple moving average. For the upper band, add the standard deviation to the moving average. For the lower band, subtract the standard deviation from the moving average.
Typical values used-
Short term: 10 day moving average, bands at 1.5 standard deviations. (1.5 times the standard dev. +/- the SMA)
Medium term: 20 day moving average, bands at 2 standard deviations.
Long term: 50 day moving average, bands at 2.5 standard deviations.
How it indicator works
When the bands tighten during a period of low volatility, it raises the likelihood of a sharp price move in either direction. This may begin a trending move. Watch out for a false move in opposite direction which reverses before the proper trend begins.
When the bands separate by an unusual large amount, volatility increases and any existing trend may be ending.
Prices have a tendency to bounce within the bands’ envelope, touching one band then moving to the other band. You can use these swings to help identify potential profit targets. For example, if a price bounces off the lower band and then crosses above the moving average, the upper band then becomes the profit target.
Price can exceed or hug a band envelope for prolonged periods during strong trends. On divergence with a momentum oscillator, you may want to do additional research to determine if taking additional profits is appropriate for you.
A strong trend continuation can be expected when the price moves out of the bands. However, if prices move immediately back inside the band, then the suggested strength is negated.