Bollinger Bands are a technical indicator that can help traders to identify the volatility and trend of a security’s price. They basically consist of three lines: a simple moving average (SMA) and two bands above and below it that are based on the standard deviation of the price. The standard deviation is a measure of how much the price varies from the average.
The SMA is usually calculated using a 20-day period, but it can be adjusted to suit different time frames and preferences. The bands are default set at two standard deviations away from the SMA, but they can also be modified. The bands widen and narrow depending on the volatility of the price.
In this article we are going to discuss the bollinger band indicator about what they are and how to use them.
What is the Bollinger Band?
Bollinger Band is an indicator which helps traders to identify the volatility and trend of an asset’s price. They basically consist of three lines: a simple moving average (SMA) and two bands above and below it that are based on the standard deviation of the price. The standard deviation is a measure of how much the price varies from the average.
Bollinger Band is both lagging and leading indicator which depends on the interpretation of the trader or investors.
Using bollinger band a trader can also identify that if the price is at an overbought or oversold zone but a trader should not use this indicator to buy or sell on the basis of overbought and oversold zones.
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How Bollinger Band Works And How to Use Them?
Bollinger Band is used by many traders in many ways. Bollinger band is also used to calculate the volatility in the underlying asset. When the bands widen and narrow it represents the volatility of an asset. When the price is more volatile, the bands expand and when the price is less volatile, the bands contract.
When the bands tighten during a period of low volatility, it raises the likelihood of a sharp price move in either direction. This may begin a trending move but watch out for a false move in the opposite direction which reverses before the proper trend begins.
When the band expands more than usual, this means that volatility has increased too much and the trend may end soon.
Prices have a high tendency to bounce within the bands’ envelope, touching one band then moving to the other band. You can use these swings to help identify potential profit targets. For example, if a price bounces off the lower band and then crosses above the moving average, the upper band then becomes the profit target.
Price can exceed or break through the envelope for prolonged periods during strong trends. On divergence with a momentum oscillator, you should use other price action concepts to filter out and confirm your trades.
A strong trend continuation can be expected when the price moves out of the bands. However, if prices move immediately back inside the band, then the suggested strength is nullified.
Also there are several traders which use Bollinger Bands to identify overbought and oversold zones which is when the price reaches or breaks through the lower band, then the price has reached the oversold zone. Similarly, when the price breaks through the upper band or reaches the upper band then the price has reached the overbought zone but this approach does not work in the real market since there are a lot of examples when price breaks through the bands to establish or continue their strong trend.
How To Calculate Bollinger Band?
First, calculate a simple moving average. Next, calculate the standard deviation over the same number of periods as the simple moving average. For the upper band, add the standard deviation to the moving average. For the lower band, subtract the standard deviation from the moving average.
The formula is expressed below:
- Middle Band = SMA of closing prices
- Upper Band = Middle Band + (Standard Deviation x Factor)
- Lower Band = Middle Band – (Standard Deviation x Factor)
Conclusion
Bollinger Bands is an indicator to filter out your trades and to confirm your analysis but using price action and combining these concepts with price action is going to improve your accuracy and winning percentage.