John Bollinger, a long-time technician of the markets developed the technique of using moving averages with two trading bands, not unlike using envelopes on either side of a moving average. Unlike using a percentage calculation from a normal moving average, Bollinger Bands simply add and subtract a standard deviation calculation.

What does all this mean? Well, let's start with standard deviation. Standard deviation is a mathematical formula that measures volatility, showing how the stock price can be spread around it's "true value". The technician can be relatively certain that almost all of the price data needed will be found between the two bands.

Bollinger Bands consist of a centerline and two price channels, one above the centerline and one below. The centerline is an exponential moving average, and the price channels are standard deviations of the stock the chartist is studying. The bands will expand and contract as the price action of an issue becomes volatile (expansion) or becomes bound into a tight trading pattern (contraction).

A stock may trade for long periods of time in a trend, albeit from time to time with some volatility. To better see the trend, traders use moving averages to filter the price action. This way, traders can gather important information regarding how the market is trading. For example, after a sharp rise or fall in the trend, the market may consolidate, trading in a narrow fashion and criss-crossing above and below the moving average. To better monitor this behavior, traders use price channels, which are designed to encompass the trading activity around the trend.

We know that markets trade erratically on a daily basis even though they are still trading in an uptrend or downtrend. We also know that technicians use moving averages with support and resistance lines to anticipate the price action of a stock. Upper resistance and lower support lines are first drawn and then extrapolated to form channels within which the trader expects prices to be contained. Some traders draw straight lines connecting either tops or bottoms of prices to identify the upper or lower price extremes, respectively, and then add parallel lines to define the channel within which the prices should move. As long as prices do not move out of this channel, the trader can be reasonably confident that prices are moving as expected.

Traders know that when the stock price continually touches the upper Bollinger Band, the price is thought to be overbought and conversely, when they continually touch the lower band, the prices are thought to be oversold, and a buy signal would thus kick in.

When using Bollinger Bands, designate the upper and lower bands as price targets. If the price deflects off the lower band and crosses above the 20-day average (which is the middle line), the upper band comes to represent the upper price target. In a strong uptrend, prices usually fluctuate between the upper band and the 20-day moving average. When that happens, a crossing below the 20-day moving average warns of a trend reversal to the downside.

Source: Tradestation

You can see in this chart of Nortel Networks from the start of 2001 that for the most part the price action was touching the lower band and the stock price fell from the $40 level in the dead of winter to its October position of $5.69. There were a couple of instances that saw the price action cut through the centerline (mid- January and early April), but for many traders, this was certainly not a buy signal as the trend had not been broken.
 

Source: Tradestation

In the 2001 chart of Microsoft Corporation, you can see the trend reversed to an uptrend in the early part of January, but look how slow it was in showing the trend change. Before the price action crossed over the centerline, the stock price had moved from $40 to $47 and then on to between $48 and $49 before some traders would have confirmation of this trend reversal.

Now, this is not to say that Bollinger Bands aren't a well regarded indicator of overbought or oversold issues, but it is charts like the Microsoft layout that may remind us of what Ralph Acampora said once in an interview on CNBC: "Start each day remembering the basics of technical analysis. Start with recognizing trends and then simple moving averages, and leave the more 'exotic indicators' to last."

by Investopedia Staff, (Contact Author | Biography)

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