One of the most popular philosophies in the trading and technical analysis universe is: ‘the trend, is your friend’; Things, however, begin to become amiss when the trend becomes your enemy. To discover a change in the trend (market being over-bought/sold), the Bollinger Bands come in to play.
These indicators were developed, as well as introduced by John Bollinger and are one of the most popular indicators in any market, whether investors are handling stocks, bonds or even Forex.
The Bollinger Bands help investors/traders to identify whether or not a price is relatively high or low, as compared to the recent average and predicts when it may rise or fall in the future; this eventually may aid investors/traders to decide on the buy or sell of an asset.
The Bollinger bands display volatility, and are placed under, as well as above a moving average; since volatility is determined by measuring standard deviation, it will change with an increase, as well as a decrease in the value of the asset in question.
The bands automatically widen whenever there’s narrow decrease in volatility or an increase. They are also used on different securities with standard settings due to the dynamic nature which they have. For signals, Bollinger Brands are useable in order to determine M-top and W-bottom formations or to identify the strength of the trend related.
Typically the Bollinger consists of 2 bands; the inner band is a simple moving average that is set at 20 intervals; a simple moving average is used in such situations as the standard deviation formula uses it as well. The look-back period for the standard deviation is identical as for the simple moving average.
On the other hand, the outer band is set to 2 standard deviations above and below the inner band. Such settings are modifiable with regards to the style of the security or the trading strategy (style)
Bollinger Bands are most useful in determining overbought and oversold levels.
An asset is considered overbought from the moment that is being trading at a high price; this can be identified using Bollinger Brands when the price reaches the outer band. There are very low chances that the price will be going up further, so traders may look to sell the asset(s) with the thought and hope that the price may fall back down to the inner moving average band
The complete opposite of overbuying whereby the price of an asset reaches the inner band; in such cases, the prices of the asset(s) are relatively low and considered to be over-sold. At this point, traders may buy the asset, with the hopes of making a profit when the value leans to the middle band levels.
Please note: In both of the above situations, the guarantee is not certain that the prices will reverse, simply because they are too high, or too low; wrong moves, as well as predictions, do occur. To further improve predictions, traders can look at the candlestick patterns – as well as other indicators.