Bollinger Bands

Bollinger Bands are a widely used technical analysis tool created by John Bollinger in the 1980s. They are used to measure market volatility and identify potential overbought or oversold conditions in financial assets like stocks, commodities, or currencies.

Definition

Bollinger Bands consist of three lines:

1. Middle Band: This is typically a Simple Moving Average (SMA) of the closing prices for a certain number of periods.
2. Upper Band: This is set a certain number of standard deviations above the middle band.
3. Lower Band: This is set the same number of standard deviations below the middle band.

The spacing between the upper and lower bands can indicate market volatility: wider bands suggest higher volatility, and narrower bands indicate lower volatility.

Calculation

1. Middle Band: Calculate the SMA for a specific period (commonly 20 days).

Middle Band = 20-day SMA of Closing Prices

2. Standard Deviation: Calculate the standard deviation of the closing prices for the same period.

3. Upper and Lower Bands: Set the upper and lower bands at 2 standard deviations above and below the middle band, respectively.

Upper Band = Middle Band + (2 × Standard Deviation)

Lower Band = Middle Band − (2 × Standard Deviation)

Example

Let’s calculate the Bollinger Bands for a hypothetical stock:

Assume the following data:

• 20-day SMA of the stock = $50
• Standard Deviation of the stock over 20 days = $2

1. Middle Band: Middle Band = 50
2. Upper Band: Upper Band = 50 + (2 × 2) = 54
3. Lower Band: Lower Band = 50 − (2 × 2) = 46

So, the Bollinger Bands for this stock are: Middle Band at $50, Upper Band at $54, and Lower Band at $46.

Usage in Financial Analysis

• Volatility Analysis: The width of the bands helps in understanding the volatility of the asset.
• Overbought/Oversold Conditions: Prices touching or exceeding the upper band may indicate an overbought condition, while touching or dropping below the lower band might suggest an oversold condition.
• Squeeze: A “squeeze”, where the bands come close together, might indicate that a sharp price move is likely to occur.
• Price Targets: The bands can also serve as potential price targets or reversal points.

It’s important to use Bollinger Bands in conjunction with other indicators, as they do not indicate the direction of the move, only the potential volatility and relative price levels.