Introduction
Bollinger Bands are a type of trading envelope. They are lines at an
interval around the moving average. They consist of a moving average and
two different standard deviations represented as a line above the MA
(Moving Average) and a line below the MA. The line above is the MA plus
two standard deviations; the line below is the MA minus two standard
deviations. Bollinger Bands are used to determine overbought and
oversold conditions and to project price targets.
John Bollinger, created Bollinger Bands in an effort to gage the
volatility and condition of a market. These bands are used to determine
the trading range and give an indication of when to buy and when to
sell. Bollinger bands are also used to indicate market volatility, the
wider the bands the greater the volatility. Inversely, the narrower the
bands, the lesser the volatility. By plotting two lines at an interval
around a moving average, Bollinger bands give a good indication of
market conditions and price relation. The moving average which the band
is based on works as an indicator to confirm trade signals.
Interpretation
The most basic use of the Bollinger Band is to look for a chart top that
occurs above the uppermost band, followed by another top that is below
the upper band. This set of chart tops would create a sell signal, as
neither upward price direction was able to sustain a rally.
The opposite would occur for a buy signal. There would be a chart bottom
below the lower band followed by a bottom above the lower band. This is
a buy signal because neither sell was able to continue, indicated by one
below and the other above the lowest band.
Calculation
Parameters:
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Period (20) - the number of bars, or
period, used to calculate the study. John Bollinger, the creator of
this study, states that those periods of less than ten days do not
seem to work well for Bollinger Bands. He says that the optimal
period for most applications is 20 or 21 days.
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Standard Deviation (2) - the percent
of one standard deviation. John Bollinger suggests that if you
reduce the number of days used to calculate the bands, you should
also reduce the number of deviations and vise versa. For example,
200 percent of a standard deviation means two deviations above and
two deviations below the moving average. If you use a period of 50,
you may want to use 250 percent of a standard deviation. For a
period of 10, you may want to use 150 or 100 percent.
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Formula:
1. Calculate the moving average. The formula is:
Pn: The price you pay for the nth interval.
n: The number of periods you select.
2. Subtract the moving average from each of the individual data points
used in the moving average calculation. This gives you a list of
deviations from the average. Square each deviation and add them all
together. Divide this sum by the number of periods you selected.
3. Take the square root of d. This gives you the standard deviation.
 4. Compute the bands by using the following formulas:
Pn: The price you pay for the nth interval.
n: The number of periods you select.
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