Bollinger Bands®, shown in Figure 1, are one of the most widely used volatility indicators in today's market analysis. This technical indicator was developed by John Bollinger in the 1980s. At the time, volatility was generally believed to be static. Price bands had been in existence but typically were created using a moving average and a fixed percentage above and below the moving average to create price bands or moving average envelopes.

Figure 1: Bollinger Bands® applied to a daily chart of the EURUSD currency pair.

One of John Bollinger's challenges was to create a technical trading tool to fill the need for adaptive trading bands that incorporated the concept that volatility was undeniably dynamic. Bollinger focused on volatility as the key variable, and used standard deviation to set band width, rather than the previously used fixed percentage. Bollinger was attracted to standard deviation because of its sensitivity to extreme deviations, resulting in bands that could react quickly to large market moves. By measuring price volatility, Bollinger Bands® became a dynamic indicator that reacts to changing market conditions. When there is more volatility in the markets, the bands widen. Conversely, when there is less volatility, the bands contract.

Calculating Bollinger Bands®
The Bollinger Bands® indicator is a set of three curved lines (bands) that are drawn in relation to an instrument's price (see Figure 1). The middle band is a moving average (MA) that measures the intermediate-term trend, and serves as the basis for the upper and lower bands. The upper and lower bands provide a relative definition of high and low. When price is at the upper band it is considered high; when price is at the lower band it is considered low. The relative distance between the outer bands is determined by volatility. The upper and lower bands are calculated by adding a specified number (N) of standard deviations (usually two) to the MA to create the upper band, and subtracting N standard deviations (usually two) from the MA to create the lower band. The simplified calculation is as follows:

Middle band = N-period simple moving average

Upper band = Middleband + (number of standard deviations x standard deviation)

Lower band = Middle band - (number of standard deviations x standard deviation)

Bollinger Band® Settings
Moving Average
The moving average that is used with Bollinger Bands® should be descriptive of the particular time frame.

In Bollinger's words, "The easiest way to identify the proper average is to choose one that provides support to the correction of the first move up off a bottom. If the average is penetrated by the correction, then the average is too short. If, in turn, the correction falls short of the average, then the average is too long. An average that is correctly chosen will provide support far more often than it is broken."

In other words, Bollinger Bands® will be far more useful when the most appropriate moving average for the instrument and time frame is selected. As a starting point, a 20-period MA works well.

Price Measurement
Another important setting to consider is the measure of price in the calculations. Closing prices are commonly used; however, other methods include typical price and weighted close:

Typical price = (high + low + close) / 3

Weighted close = (high + low + close + close) / 4

Using one method or another is a matter of choice, and very often depends on the particular instrument and timeframe.

Standard Deviations
Traders must also specify the number of standard deviations used in calculating the upper and lower bands. Smaller standard deviations will allow the upper and lower bands to remain closer to price. Conversely, larger standard deviations will result in bands that are further from price. Many traders start with two standard deviations, and venture out from there, in very small increments, such as 1.9 or 2.1, until a desired setting is achieved. MT4 does not allow non-integer values in the Standard Deviation input setting. Traders can use the "Levels" tab to work around this limitation (discussed in the "Customizing Bollinger Bands®" section of this article).

Next: How To Apply Bollinger Bands® With Metatrader 4: Using Bollinger Bands® »

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