John Bollinger invented one of the most popular price volatility measures – the Bollinger bands.This technical indicator comprises:
an upper band,
a lower band and
a 20-day simple moving average of the closing price.
Both the upper and lower bands are 2 standard deviations above and below the moving average.The 20-day moving average is the number of days that Bollinger’s research showed is the most effective in detecting variance. The bands display relative highs and relative lows in the context of the moving average – they’re adaptive to the price by the amount of the standard deviation. The bands are moving standard deviations.
An interpretation of the bands is based on the premise that the vast majority of all closing prices should be between the Bollinger Bands. Thus, a stock’s price going outside the Bollinger Bands, which occurs very rarely, should not last and should ‘revert back to the mean’. The general interpretation to Bollinger Bands is:
Buy when the price falls below the lower Bollinger band
Sell when the price pierces outside the upper Bollinger band
Bollinger Bands are effective for spotting trends by virtue of the widening and narrowing bands. An impending narrowing of the bands indicates the end of a trend and the start of consolidation, while the widening of the bands indicate the start of a trend.
As with most indicators, confirmation of buy/sell signals should be done with the presence of other indicators such as momentum and the candlestick price chart itself.
Look out for more indicators in subsequent issues.