Bollinger Bands are a popular overlay used by traders and used to indicate volatility. Developed by the market technician John Bollinger, the indicator takes an exponential moving average (EMA) which is bracketed by lines showing the upper and lower standard deviation added to, and subtracted from, the moving average.
The default settings are usually a 21-period EMA with bands 2 standard deviations above and below the moving average. The standard deviation bands illustrate the volatility as the price of the underlying market moves.
The bands expand as volatility picks up and contract as it declines. Traders watch the upper band as a potential area of resistance and the lower as support. In addition, when the bands contract, this is a sign that volatility is decreasing and prices are consolidating. Often a period of consolidation ends with a price break-out which traders look to take advantage of.
The Bollinger Bands alone will not signal the direction of the break-out, so traders typically employ other technical indicators and use their own skill and knowledge to position themselves appropriately.
When the Bollinger Bands expand, this indicates that volatility is increasing. John Bollinger explained that the bands should contain close to 90% of price action.
This means that a move outside the bands is significant, suggesting that prices are relatively high above the upper band and relatively low when below the lower band. However, such moves on their own do not suggest that a financial instrument is overbought or oversold.
Consequently, traders should look for confirmation using other complementary technical indicators before opening or closing a position.
