What are Bollinger Bands?
Curiously enough, some important inventions made for the mere convenience of their creators later turned out to be real breakthroughs that many people could benefit from. A similar story happened to American financial analyst John Bollinger. In 1984, he decided to develop a whole new approach to analyzing and trading financial markets. After 7 years of continuous work, he presented the trading community with a new indicator that was highly appreciated by everyone. Soon, this innovative technique was eagerly adopted by traders from all over the world and got its name - Bollinger Bands. Although Bollinger’s brainchild was created 30 years ago, it is still widely used by modern traders. Let’s take a closer look at what makes this technical tool so unique.
Understanding Bollinger Bands
Bollinger Bands is a technical indicator that measures volatility in the market. It helps traders determine whether the current price of an asset is high or low in relation to the recent moving average. The tool can also predict a possible rise or fall in the price. The purpose of Bollinger Bands is to give investors clues on whether to buy or sell an asset.
How to use Bollinger Bands
Bollinger Bands are comprised of three lines:
- The middle line is a simple moving average.
- The upper and lower lines are levels of relative highs and lows of the asset’s price in relation to the middle band.
Notably, the distance between the bands and the MA is a variable value and is based on standard deviations. By evaluating their movements, traders can identify overbought or oversold market conditions.
- Overbought conditions
If the quote touches the upper band, an asset is trading at a high price and is considered overbought. This is a signal to sell the asset as it may soon decline to the middle band. - Oversold conditions
- Overbought conditions
If the quote hits the lower band, an asset is trading at a relatively low price and is considered oversold. This serves as a buy signal as the asset may soon roll back to the middle band.
Key Takeaways
- The indicator measures market volatility based on the distance between the upper and lower bands. The bands expand when volatility increases and contract when it decreases. These price swings usually happen amid publications of important news.
- Bollinger Bands show the existing market situation by forming a channel where the price is moving.
- However, the technical tool does not reflect real-time price movements and, therefore, cannot accurately predict where the asset will move next. Still, this indicator regularly generates valid signals with high profit potential.
- Importantly, Bollinger Bands should not be used as a standalone tool. Yet, many traders rely solely on this trading system. If you want to use several tools, Bollinger Bands can be successfully combined with the RSI, MACD, and other indicators.
- Bollinger Bands can be applied to such commonly used time frames as minute, hourly, and daily charts.
