Bollinger Bands (BBs) are one of the most popular and versatile technical analysis tools used by traders and investors to gauge market volatility and determine a stock's price range relative to its average. Developed by financial analyst John Bollinger in the 1980s, this indicator provides a dynamic framework for understanding when a market is relatively calm or turbulent, and whether prices are at extremes.

What Are Bollinger Bands?

A Bollinger Band indicator is typically plotted on a price chart and consists of three main lines:

1. Simple Moving Average (SMA): The middle band is usually a 20-period SMA, which serves as the base for the indicator and represents the average price over that time frame.
2. Upper Band: Calculated by adding a set number of standard deviations (usually two) to the Middle Band.
3. Lower Band: Calculated by subtracting the same number of standard deviations from the Middle Band.

The core concept is based on the statistical measure of standard deviation, which quantifies the amount of variation or dispersion of a set of values (in this case, price) from its mean (the SMA).

Identifying Market Volatility

The distance between the Upper Band and the Lower Band is the key to identifying market volatility. This is the primary function of Bollinger Bands.

The Standard Deviation Connection

Standard deviation is a direct measure of volatility. When the market is volatile, prices fluctuate wildly, leading to a larger standard deviation. Conversely, when the market is quiet, prices are stable and close to the average, resulting in a smaller standard deviation.

1. High Volatility (Band Expansion): When the price bars show large movements, the standard deviation increases, causing the Upper and Lower Bands to widen or expand. This expansion signals a period of high volatility or the start of a significant price move.
2. Low Volatility (Band Contraction): When the market is quiet and prices are trading sideways within a narrow range, the standard deviation decreases. The Upper and Lower Bands move closer together, a phenomenon known as "The Squeeze." The Squeeze often precedes a period of high volatility, as the market is "resting" before a breakout. Traders frequently watch for a contraction as a sign that a significant move is imminent, though it doesn't indicate the direction.

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Determining the Price Range and Extremes

Bollinger Bands also act as a dynamic price envelope that helps traders assess if the current price is relatively high or low.

The Statistical Significance

With the typical setting of two standard deviations, the bands are designed to contain approximately 95% of the price action. This statistical characteristic makes the bands excellent indicators of extreme price levels.

1. Price Near the Upper Band: When the price approaches or touches the Upper Band, it suggests the asset is relatively overbought or trading at a high price compared to its recent average. This doesn't necessarily mean the price will immediately reverse, especially in a strong uptrend, but it signals an extreme.
2. Price Near the Lower Band: Conversely, when the price approaches or touches the Lower Band, it suggests the asset is relatively oversold or trading at a low price compared to its recent average. This signals a potential support level or an extreme low.

The "Walk the Band" Phenomenon

In a strong trend, prices may hug or "walk" along one of the bands.

1. Uptrend: In a strong uptrend, the price will often touch or run along the Upper Band, with the Middle Band (SMA) acting as support. This suggests the strength of the trend is pushing the price to consistently higher highs.
2. Downtrend: In a strong downtrend, the price will often touch or run along the Lower Band, with the Middle Band acting as resistance. This indicates strong selling pressure.

The Trading Range Indicator

When a market is range-bound and not trending, the price tends to revert to the mean (the Middle Band). Prices will bounce between the Upper and Lower Bands, giving traders clear entry and exit points based on the assumption that prices will move back toward the average after hitting an extreme band.

Conclusion

Bollinger Bands are more than just two lines surrounding a moving average; they provide a dynamic, visually intuitive measure of volatility. By constantly adjusting to market conditions, they give traders vital context: is the market quiet, suggesting a big move is coming (The Squeeze)? Is the market turbulent, confirming a strong trend (Band Expansion)?

Author: Darius Elvon