Bollinger Bands indicator is like Envelopes but these lines are plotted above and below a selected simple moving average of the price. A standard deviation is used for the plot. When you’re viewing Bollinger Bands, they help you to understand whether prices are low or high, by comparing them to other prices.
Bollinger Bands are always used in pairs, so you always have a higher and lower band. The simple moving average is always in between these outer bands. Bollinger Bands adjusts immediately to any price changes because they’re based on standard deviation. If the underlying price is rapidly changing, the bands will reflect that.
Evaluating the Bollinger Bands indicator
There are two parameters that you’ll always need to keep in mind when you’re evaluating the Bollinger Bands indicator. These are the standard deviation and the period that’s being assessed. Usually, 20 is used for the period and 2 for the standard deviation but you can adjust this slightly.
You should never use the outer bands on their own. You also shouldn’t make decisions based on Bollinger bands, without checking other indicators first. If you’re assessing a period of volatility and notice that the bands are tightening, this means that the price could move sharply. This movement could take place in either direction.
It’s never wise to make a buy or sell decision-based on the first sign of tightening because sometimes there’s a false movement in a particular direction. This then corrects itself. In fact, sometimes prices bounce within the envelope of the bands, moving from one band to another.
If a strong trend exists, prices can exceed the band envelope or hug it for a long time. If the bands are separated by an amount that’s so large that it’s immediately noticeable, the trend may be ending. Always check the period that’s been applied with this oscillator because that affects the strategy that you choose to use for your trades.
Usually, the best period is 13 but by experimenting a bit, you may find a period that works a little better with your own strategy. Once you apply the indicator, watch how it is behaving. With a period of 13, a level below 0.3 is thought of as being oversold while a DeMarker of 0.7 and more is considered overbought.
If the market is in an overbought state, it’s usually not a good idea to start buying. When it’s overbought prices will start coming down and you could lose money if you decided to buy at that time. Many traders use the DeMarker to find overbought or oversold levels and they make buying or selling decisions based on that.
Calculating Bollinger Bands
Three lines are used to form the Bollinger Bands indicator. These are the:
- Middle line (ML)
- Top line (TL)
- Bottom line (BL)
In the calculations below, the following symbols are used:
- N = the number of periods
- SMA = Simple Moving Average
- StdDev = means Standard Deviation
A usual Moving Average forms the middle line, which is calculated as. ML = SUM [CLOSE, N]/N
The top line is almost the same as the middle line but is shifted up by several standard deviations (D).
TL = ML + (D*StdDev)
The same number of standard deviations are used to shift the bottom line.
BL = ML – (D*StdDev)
StdDev = SQRT(SUM[(CLOSE – SMA(CLOSE, N))^2, N]/N)
It’s best to use a 20-period Simple Moving Average for the middle line in your calculations. Use two standard deviations on either side for TL and BL. Moving Averages of 10 periods or less don’t have much of an impact.