Bollinger Bands are a technical indicator used on a price chart by technical analyst traders, or technical traders in short, to identify whether the asset in a market is either overbought or oversold and to measure the volatility of the asset’s price.
John Bollinger, the world-famous technical analyst trader, is the creator of the Bollinger Bands. He based his creation on the statistical observation that: 95% of the time, prices will stay within the standard deviation from the mean.
Bollinger Bands consist of 3 lines on a chart, with the middle line being a 20 period Simple Moving Average (SMA) and the outer lines being the upper band and the lower band respectively, which are typically 2 standard deviations +/- from the 20-S.M.A, but can be modified.
Overbought/Oversold & Intrinsic Value
An overbought market is where an asset’s price is trading higher than its intrinsic value, while an oversold market is the opposite; the price is trading lower than the intrinsic value of the asset.
Intrinsic value is the value of an asset, a company or an investment that is either perceived by traders and investors or calculated using a mathematical formula.
It is fundamental analysis term mostly used in stock trading when evaluating the cash flows of a company as well as the company itself.
It can also be used to describe the profitability of an Options contract, where high intrinsic value would mean high profitability.
Fiat money, or modern currency, has no intrinsic value of itself and is dependent on the perceived value and strength of the economy and government that issued it.
Both overbought and oversold are seen by technical analysts as market moves that are soon followed by a correction. This allows them to profit from the upcoming correction by going long or short depending on each situation accordingly.
On a price chart with Bollinger Bands, when the price moves upwards and nears the upper band the more the market is considered overbought while when the price moves closer to the lower band the more the market is considered oversold.
Measuring Price Volatility
When there is high price volatility the bands widen with the upper band moving towards the top of the chart and the lower band moving towards the bottom
When volatility is low and the price is near the SMA, they contract to form the ‘’Squeeze’’ which some analysts view as the calm before the storm, anticipating sudden and high upcoming volatility.
Trading with Bollinger Bands
While an important and frequently used indicator, Bollinger Bands cannot provide a reliable signal to trade and shouldn’t be used by traders for this purpose.
They are appropriately used as a trading tool by technical traders to estimate market price probabilities and price volatility fluctuations, not as a tool to derive trading signals from.