How to trade using Bollinger Bands.

Technical Analysis – Bollinger Bands.

The Bollinger bands were first developed by John Bollinger, a financial analyst, during the 1980s.Today the Bollinger Bands are a widely used trading tool in any market. The Bollinger Band consists of 3 components – an exponential moving average formed at the centre, a standard variation upper band above the center moving average and standard variation lower band below the center moving average. The centre line is usually a 20 day moving average. This line is accompanied by two standard deviation lines. The upper Bollinger Band calculation is arrived by adding   2 * 20-period standard deviation to the Middle Bollinger Band. The lower Bollinger Band calculation is arrived by subtracting 2 * 20-period standard deviation from the Middle Bollinger Band   

As an indicator the Bollinger Band will display the distance between the upper and lower Bollinger Bands. It can be said this is an index of volatility. Higher band width denotes the underlying stock’s volatility is very high. Similarly Lower band with tells us the underlying stock is least volatile. The higher band width also indicates the current trend in the underlying stock may be coming to an end. The lower band width suggests that a new trend is likely to begin.

How to use the Bollinger Bands 

 The upper and lower bands are assumed as possible price targets. Therefore if the prices bounce off the lower band and move passing the center line we can understand it as a trend reversal and the upper band becomes the target price to watch for. On the other hand if the price touches the upper band and finds it unable to sustain, we take this as a point of resistance. Shorts can be built with the lower band becoming the price target.

Another most important point to note is the contraction and expanding Bollinger Bands. This pattern can be noticed in any charts. This is actually an indication of the large and lesser price movement. We normally witness a breakout or a breakdown after a contraction. Similarly after a large expansion of the Bollinger Band we can observe a change in the trend of the underlying stock.

Bollinger Bands can be a great help in determining the overbought and oversold levels in a given market. When the price travels along the upper band, it is an indication of overbought levels. This is also an early warning for a trader, cautioning him not to jump in to trade. When the price movement is based along the lower band it is an indication of oversold levels. At oversold levels traders usually expect a price correction. At oversold levels a pullback may be expected from a trader’s point of view this can be an opportunity for investing and seek quick profits. One point I should mention here is that on lower band the price tend to stay for a longer periods. 

Like any other indicators the Bollinger Band is not a perfect standalone trading system. Therefore It may be necessary to look at other indicators also for confirmation. For a disciplined trader who believes in technical analysis the Bollinger Bands is a must have tool, that cannot be ignored.