During the 1980s, famed technical trader John Bollinger developed the well-known and highly-regarded indicator called Bollinger Bands. The technique behind the Bollinger Bands is very simple and consists of a moving average band accompanied by a band sitting just above it and another sitting just below it. when analyzed properly, Bollinger Bands can help traders measure market volatility and can also serve as an excellent indication to set targets based on overbought and oversold conditions.
Bollinger Bands work by calculating a standard deviation, which in turn measures the volatility of a stock. Volatility shows how much risk is involved in a particular stock and how far its price can deviate from its real value. For example, the price of a stock that is highly volatile can change dramatically, whereas a less volatile stock is unlikely to display such fluctuation. By measuring price volatility one can adjust to market conditions effectively.
How does all this work when a trader decides to use Bollinger Bands as an indicator?
Firstly, the line in the center of the Bollinger Bands is known as an Exponential Moving Average. This is a line that reacts quickly to any price changes in the particular stock. The two outer bands, on the other hand, present the standard deviation of that particular stock. As the bands expand or contract a trader can analyze these movements and assess the volatility of that stock at a particular point in time. The standard deviation of the upper and lower band indicates the predictable range of the stock based on its history and so the price is likely to stay somewhere between those two bands.
How can this analysis then be used to set targets and play the market to my advantage?
The most obvious and commonly used technique when analyzing the Bollinger band indicator is to use them as part of a range trading technique. Generally, when the price of a stock hits the upper band it indicates that the stock is becoming overbought and is usually a good time to sell, because the price is likely to bounce down towards the lower band. When the stock then hits the lower band it is becoming oversold and that is a particularly good time at which to buy because the price is then prone to rise. This pattern often repeats itself and by analyzing the trend of the stock a trader can set targets to buy and sell when it hits the lower and upper bands. Keep in mind, that it is not a good idea to enter a position when the price is hovering around the Exponential Moving Average, because the price could move in either direction.