Bollinger Bands

Bollinger Bands consist of three lines: a simple moving average line (SMA) in the middle, and two band lines lying standard deviations above and below this mean. This construction creates dynamic bands that expand and contract based on the market's volatility. When the market is calm and price movements are small, the bands draw together.

When volatility increases, as at important news or market upheavals, the bands expand sharply. This dynamic nature makes Bollinger Bands a direct gauge of the market's nervousness and a crucial component for understanding the underlying volatility behind a stock's movements.

This indicator is crucial because it offers a contextual framework for assessing whether a stock's current price is 'normal' or 'extreme'. A price moving within the bands is considered to be in a normal trading state, while a price breaking through a band signals a potential continued movement in that direction.

This context is invaluable, because it helps the analyst distinguish between a temporary correction and a fundamental turning point. It is not just about where the price is, but where it sits in relation to its normal volatility range.

The most famous strategy is 'Bollinger Bounce', where a stock that has moved to the upper band is sold, and one that has moved to the lower band is bought. This strategy builds on the assumption that the price tends to return to its mean, a principle known as 'mean reversion'. This method is especially effective in sideways (ranging) markets, where prices move within a fixed interval.

When the stock reaches the upper band, it is considered 'overbought' relative to its normal volatility range, and when it reaches the lower band it is considered 'oversold'. An analyst using this method must, however, combine it with confirmation from other indicators, such as volume increases at band touches, to avoid false signals.

A more advanced application is the 'Squeeze'. A 'Squeeze' occurs when the two band lines draw very close to each other, indicating extremely low volatility. Historically, periods of low volatility have often preceded large, explosive movements up or down. A 'Squeeze' thus signals a coming period of increased volatility, but gives no indication of direction.

For an analyst, this is a warning that a period of stability is about to break and that one should prepare for a larger event, either by adjusting positions or by being extra observant of breakout patterns.