BB - Bollinger Bands

Bollinger Bands are used to determine whether the market is oversold or overbought. They are usually based on simple moving average and two standard deviations whereas one can be found bellow and the other one above the moving average.

Bollinger bands, are in fact two curves, which are approaching or retreating from the middle value - the moving average of the price. Most often a 20-days moving average is chosen.

Bollinger Bands are based on the statistic fact that 95 % of all values are within the double standard deviation limits (either above or bellow the moving average) and just 5 % of the values are beyond them.

The trader can choose his own setting, of course. It needn't to be the double standard deviation. If he decides to use the tripple standard deviaton limits, he can make use of the 99 % statistic probability of all the values being inside the limits. Just 1 % of the values is beyond the limits in such case. Should the overload occur, the traders have much higher probability that the correction of the unexpected price move would occur. The price allways tends to return to the predetermined limits.

Upper BB limit:  n-days moving average + X-multiple of the n-days standard deviation

Lower BB limit:  n-days moving average - X-multiple of the n-days standard deviation

Copyright © Picture made by IncredibleCharts

There is a 20-days simple moving average and 2 standard deviations oscillating in the distance of 2-multiple SD around the average on the picture.

As the standard deviation is an expression of the market volatility, the Bollinger Bands are adapted to the current market situation. That's how the Bollinger Bands define the price limits under the prevailing conditions. If the price rises above the upper limit of the BB, there is a great chance of its decreasing, back to the limits, very shortly. If the price falls bellow the lower limit, the opposite is true.

The limit overload does not mean automatically a signal to buy or sell, just increase the probability of correction, or drives the attention of the traders to possible change. There is also another fact - if the price moves out of the limits, it will probably continue to hold the prevailing trend. The expected return into the limits is just a temporary correction. The reversals are usually defined by new High/Low outside limits, followed by new High/Low inside the limits. Price tends then to return to the middle values, which is just the moving average of the prices.

Price can also break through the middle average and continue to the other Bollinger Band. During less volatile trading the BB use to be close enough, while during very volatile trading they move away. If the Bollinger Bands are very close the average (i.e. the market volatility is low), it is desirable to prepare for sudden market swings very soon. The swings can be each way - either up or down.

Note: The lower timeframe we choose, the higher multiple of Standard deviation we should use. E.g. if we choose the 15-min time frame, it's better to use 3-multiple of the Standard Deviation, instead of the usual 2-multiple. Of course we can combine the multiplies and display 2-multiple as well as 3-multiple in the graph. In such case beware of the false breaktroughs. The price can be trending and moving between these multiplies for a long time.

If you are interested in a deeper study of this technical indicator and prefer ready to serve solutions, this may be of  interest to you. There you can find all the available indicators in Excel file for download.