What are Bollinger Bands?
Bollinger Bands consist of three lines: a simple moving average in the middle (usually 20 periods) and two bands above and below it, drawn at a distance equal to two standard deviations from the average. Instead of showing trend direction, this tool visualizes price's natural range of volatility.
How it's calculated
The middle band is simply the 20-period simple moving average. The upper band comes from adding twice the price's standard deviation over that same period to the middle band, and the lower band comes from subtracting that same amount. The more volatile the market gets, the larger the standard deviation, and consequently, the more the bands spread apart from each other.
How to read the chart
The bands widening apart signals rising market volatility, and them squeezing together (called a “squeeze”) signals falling volatility and a calming market, which is often the prelude to a sharp, sudden move. Price moving near the upper band sits within a strong uptrend, and closeness to the lower band signals a strong downtrend.
Trading signals
One common signal is price touching the upper or lower band in a ranging market; under such conditions, some traders expect price to revert back toward the middle band. Another signal is a breakout from a Bollinger Squeeze, which is usually accompanied by a sharp rise in volatility and the start of a new trend; the direction of this breakout shows the market's next likely direction.
Strengths and limitations
Bollinger Bands do a good job of visualizing market volatility, but price touching the upper or lower band alone shouldn't be treated as a sell or buy signal; in strong trends, price can ride along one of the bands for a long time without reverting to the average.
Practical tip
Combining Bollinger Bands with RSI can raise accuracy; for example, price touching the lower band at the same time as an oversold reading on RSI provides a stronger signal for a possible price reversal.