Bollinger Bands are a technical analysis tool invented by John Bollinger in the 1980s. Having evolved from the concept of trading bands, Bollinger Bands can be used to measure the highness or lowness of the price relative to previous trades.
The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition, prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions
Bollinger Bands serve two primary functions:
- To identify periods of high and low volatility
- To identify periods when prices are at extreme, and possibly unsustainable, levels.
Because standard deviation is a measure of volatility, Bollinger bands adjust themselves to the market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average). The tightening of the bands is often used by technical traders as an early indication that the volatility is about to increase sharply.
This is one of the most popular technical analysis techniques. The closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. s
When stock prices continually touch the upper Bollinger band, the prices are thought to be overbought; conversely, when they continually touch the lower band, prices are thought to be oversold, triggering a buy signal.