Bollinger bands were developed by John Bollinger and are used to measure volatility. Bollinger bands use 3 lines, the centre line being the moving average and the two outer lines are the standard deviation. Standard deviation is the volatility from the average price, this provides us with a good indication of volatility which can be a great tool to have when trading.
How is it calculated?
A Bollinger band set with a 20day moving average and a standard deviation of 2 would be:
Upper band = 20 day MA + (20 day MA x2)
Lower band = 20 day MA – (20 day MA x2)
Its not essential to know how Bollinger bands are calculated to be able to use them to trade as long as you know how to use them to aid your trading.
How to read Bollinger bands
When using Bollinger bands you need to look at the two outer bands. the close the outer bands are to the centre band the less volatile the market is, the wider the bands the more volatility there is. This can be used to identify when a market is in consolidation and when it is in a trend, when the bands are close this shows low volatility and consolidation, the longer the price is in consolidation and the bands are narrow the stronger the trend is likely to be when it forms, and when the bands are wide this shows high volatility and a possible trend forming.
How to trade Bollinger bands
There are a number of ways to trade using Bollinger bands but there are two simple ways to use them either when in a range, or in a trend.
When in a range you can trade using the the bands as a support and resistance levels, buying on the lower band and selling on the upper band. This is a good way to use the bands when in a ranging market, you can also set your stops jus outside of the bands incase the price breaks into a trend.
Another way is to wait for a break of the bands and following the trend as you would with conventional support and resistance levels, setting your stop loss just within the band. The trade could also be exited when you see the bands contracting showing a possible end of the trend.
Bollinger bands are a good tool to add to your trading, either by using them to identify a ranging or trending market or too use as dynamic support and resistance levels.