Bollinger Bands were developed by John Bollinger. The indicator consists of three bands: an upper band, a lower band and a simple moving average in the middle.
The purpose of Bollinger Bands is to compare volatility and price levels over a period of time. A standard deviation, which measures volatility, is present to allow the bands to react quickly to price movements. (See Standard Deviations) The wider the bands, the sharper the prices increase. Bollinger bands are best in indentifying periods when prices are at extremes.
To calculate the Bollinger Bands, historical daily prices of open, high, low and/or close are needed. The upper band is the sum of 20-day moving average and 2 times standard deviations; the lower band is the difference of 20-day moving average and 2 times standard deviations; the middle moving average is the average of 20-day period. A 20-day moving average period and 2 standard deviations are recommended by Bollinger, although the period and number of deviations may vary depending upon the individual preferences and type of securities.
Like other technical indicators, Bollinger Bands can help generate buy and sell signals. Conventionally, when prices penetrate the lower band, it may indicate market is oversold; when prices near the upper band, it may signal an overbought market. The bands tighten first before a sharp move in prices.
Gold – Electronic
Prices of Gold closed below the lower band in August 2007 (red circle). A subsequent trough failed to break below the lower band. A bullish trend is confirmed when prices surge above the middle moving average (green circle).
On one hand, a sell signal denotes if prices closed above the upper band and failed to break above the upper band after subsequent peaks. The bearish trend is confirmed when prices fell below the centerline.