Bollinger bands are one of the most popular technical analysis
methods in measuring volatility as well as an oversold or overbought condition
of a certain stock.
Bollinger bands were developed by John Bollinger, a very
famous technical trader. The Bollinger
Bands consists of a middle band with two outer bands. The middle band was a
simple moving average of 20 – day period computed from the stock’s closing
price. The upper and the lower bands above and below the 20-day SMA were
computed as standard deviations of the stock price.
The Bollinger Bands were computed based on the formula below.
- Middle Band = 20-day simple moving average (SMA)of Closing Price
- Upper Band = 20-day SMA + (2 x 20-day standard deviation of price)
- Lower Band = 20-day SMA - (2 x 20-day standard deviation of price)
Based on the above formula we come up with the following spreadsheet
which you can easily make through Microsoft Excel or any spreadsheet software
you have in your computer.
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| Fig. 1. Bollinger Band Spreadsheet |
Since the Bollinger Bands were calculated using standard
deviation which measures volatility, the bands adjust automatically depending
on the condition that exists in the market for a particular stock.
When the market volatility increases, the bands widen and
move away from the middle SMA line. When the market volatility decreases, the
bands become narrower and move closer to the middle SMA line. This widening and
narrowing nature of the bands signals stock market traders on possible
profitable entry or exit points in their trade.
Bollinger bands can also be used to determine if the stock
price is relatively high or low. When the price is above the upper band, the
price is said to be relatively high. Likewise, if the price is below the lower
band, the price is considered relatively low.
Below shows a Bollinger Band chart based on the
spreadsheet in Fig. 1 above.
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| Fig. 2 Bollinger Band Chart |
As a trading tool, Bollinger Bands are not advisable to be used
as a sole trade indicator. Bollinger Bands are more effective if combined with other
trend indicators such as Relative Strength Index (RSI) or Stochastic
Oscillator.