- John Bollinger, a well-known technical trader who predicted the shift in market sentiments, developed the concept of Bollinger Bands.
- Primarily used as a technical analysis tool to measure price volatility, these bands can be applied to any timeframe, from minutes to a day and beyond.
What are Bollinger Bands?
- Bollinger Bands refers to a technical analysis chart consisting of three lines: the middle band, the upper band, and the lower band.
- Typically, the middle band is a 20-period simple moving average.
- Adding and subtracting a multiple of the standard deviation of the price from the middle band helps calculate the upper and lower bands.
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How Do I Calculate the Bollinger Bands?
- The method to calculate Bollinger Bands is given below:
BOLD = SMA (TP, n) − (σ [TP, n] * m)
BOLU = SMA (TP, n) + (σ [TP, n] * m)
BOLD = Lower Bollinger Band
BLOU = Upper Bollinger Band
SMA = Simple Moving Average
n = the days in Moving Average (usually 20).
m = multiplier (usually 2).
TP= Typical Price (Low + High + Close) / 3
σ [TP, n] = SD over the last n periods of TP.
- Initially developed for analyzing the stock markets, the Bollinger Bands concept is now widely used to analyze different asset classes, including equities, commodities, and currencies.
How Do Bollinger Bands Work?
- The upper and lower bands in the Bollinger Bands chart contract during periods of low volatility and expand during periods of high volatility.
- The market conditions are estimated to reverse when the upper and lower bands meet.
- Thus, the Bollinger Bands analysis is based on the assumption that prices tend to revert to their average over time.
How Do I Use Bollinger Bands in Trading?
- Traders use Bollinger Bands to manage risk by placing stop-loss orders outside the bands.
- However, it is best to use this tool with other tools, such as the relative strength index, Fibonacci retracements, and candlestick patterns, to confirm the trend direction.
What are the Limitations of Bollinger Bands?
While the Bollinger Bands chart is an effective tool, it does come with a few limitations. Some of them are:
- External factors, such as news or events, are not considered in Bollinger Bands.
- These bands can generate false signals, specifically during periods of low volatility.
- The bands chart does not account for price gaps that can occur overnight or during market openings, potentially leading to inaccurate signals.
- If used along with other relevant technical tools, Bollinger Bands can help you measure volatility.
- They can also help you take the necessary actions to maximize your profits and minimize your risks.
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