Bollinger bands are similar to moving average envelopes. The difference between them is that the borders of envelopes are drawn above and below the moving average curve at a fixed distance expressed as a percentage, whereas the boundaries of Bollinger bands are plotted at levels equal to a certain amount of standard deviations.
” Since the standard deviation value depends on volatility, Bollinger bands are self-adjusting: widening when the market is volatile and narrowing during more stable periods. “
As a rule, these patterns are built on a price chart but can also be displayed on an indicator chart. Below we will focus on the bands that are plotted on price charts. Similar to the case with moving average envelopes, the interpretation of Bollinger bands is based on the fact that prices tend to stay within the upper and lower boundaries of a band.
” The distinctive feature of Bollinger bands is their varying width that depends on shifts in price volatility. “
During the periods of considerable price changes, the bands widen to let prices fluctuate more freely. During the periods of stagnation, the bands narrow thus curbing price volatility and containing prices within their boundaries.
- As a rule, sharp price swings occur after the bands narrow due to decreased volatility.
- When prices move outside the bands, a trader should expect a continuation of the existing trend.
- Peaks and bottoms outside of Bollinger bands followed by peaks and bottoms inside them indicate a potential trend reversal.
- Price movement that originated near one of the bands normally reaches the opposite boundary.
- This observation is useful for predicting price targets.