Bollinger bands are a trend indicator named after their creator, John Bollinger, and they indicate both the direction and volatility of a share or CFDs price movement. There are just two Bollinger bands, an upper band and a lower band, which work above and below a moving average.
The following three topics are critical in respect of Bollinger bands: How Bollinger Bands are Constructed; Bollinger Band Trading Signals; Strengths of Bollinger Bands
How Bollinger Bands are Constructed
Bollinger bands are typically based on a 20-period moving average. A moving average is sandwiched between the two bands.
A standard deviation is a statistical term that measures how far various closing prices diverge from the average closing price. The upper band is plotted two standard deviations above the 20-period moving average. The lower band is plotted two standard deviations below the 20-period moving average (see Figure 3).
Therefore, 20-period Bollinger bands tell traders how wide, and therefore volatile, the range of closing prices has been during the past 20 periods. When the price has been volatile, the bands will be wider. When the price has been relatively stable, the bands will be narrower.
Bollinger Band Trading Signal
Bollinger bands provide useful breakout signals for shares or CFDs that have been consolidating.
Entry signal – when the bands widen and begin moving in opposite directions after a period of consolidation (see Point A on Figure 4), you can enter the trade in the direction the price was moving when the bands began to widen. Clearly you are trying to capitalize on renewed volatility.
Exit signal – at some point after the breakout occurs, the bands will begin to move back toward each other (see Point B on Figure 4). When this happens, you should set a trailing stop-loss to prompt you to sell if the trend reverses (see Point C on Figure 4 ).
Strengths of Bollinger Bands
- They help you identify the trend
- They identify current market volatility
Weaknesses of Bollinger Bands
- They lag behind the market because the data used to calculate Bollinger bands is historic and cannot predict the future.
- The bands do not, as is commonly believed, serve as support (lower band) and resistance (upper band) levels.