Introduction
Bollinger Bands are a popular technical analysis tool used by traders to identify potential price trends and trading opportunities. Developed by John Bollinger in the 1980s, these bands are a type of chart indicator that uses a moving average and standard deviations to create an upper and lower band around the price chart.
What are Standard Deviations?
Standard deviation is a statistical measure that shows how much variation or dispersion there is from the average or mean. In trading, standard deviation is used to measure the volatility or price movement of an asset. The higher the standard deviation, the more volatile the market is.
How are Bollinger Bands Calculated?
Bollinger Bands consist of three lines: the moving average (usually a 20-day moving average) and two standard deviation lines, one above and one below the moving average. The upper band is calculated by adding two standard deviations to the moving average, while the lower band is calculated by subtracting two standard deviations from the moving average.
Using Bollinger Bands in Trading
Bollinger Bands are used to identify potential price trends and trading opportunities. When the price is trading near the upper band, it may indicate that the asset is overbought and due for a price correction. Conversely, when the price is trading near the lower band, it may indicate that the asset is oversold and due for a price rebound.
Bollinger Bands as Support and Resistance Levels
Bollinger Bands can also be used as support and resistance levels. When the price bounces off the lower band, it may indicate that the lower band is acting as a support level. Similarly, when the price bounces off the upper band, it may indicate that the upper band is acting as a resistance level.
Bollinger Band Squeeze
A Bollinger Band squeeze occurs when the upper and lower bands come closer together, indicating that the asset is experiencing low volatility. Traders may use a Bollinger Band squeeze as a signal that a price breakout is imminent.
Limitations of Bollinger Bands
While Bollinger Bands can be a useful tool for identifying potential price trends and trading opportunities, they are not foolproof. Bollinger Bands are based on historical price data and do not take into account external factors that may affect the market, such as news events or changes in market sentiment.
False Signals
Bollinger Bands can also generate false signals, especially in choppy or sideways markets. Traders should use other technical indicators and fundamental analysis to confirm potential trading opportunities.
Not Suitable for All Asset Classes
Finally, Bollinger Bands may not be suitable for all asset classes. The bands work best with assets that have a normal distribution of prices. Assets with non-normal price distributions, such as cryptocurrencies, may not work well with Bollinger Bands.
Conclusion
Bollinger Bands are a popular technical analysis tool used by traders to identify potential price trends and trading opportunities. While they are not foolproof, they can be a useful tool when used in conjunction with other technical indicators and fundamental analysis. Traders should be aware of the limitations of Bollinger Bands and use them appropriately.
