Bollinger bands is an indicator that plots a pair of lines on either side of a moving average, most often two standard deviations away from the moving average, and was developed by a famous technical trader named John Bollinger.
The fact that the indicator measures when prices get to be twice as far from the moving average as normal, the indicator can be used to determine overbought and oversold conditions. Also, because standard deviation can be thought of as a measure of volatility, Bollinger bands will automatically adjust themselves to the prevailing market conditions a quick manner. When the markets are a bit more volatile, the bands will widen – or move farther away from the moving average. During less volatile conditions, the bands will in turn contract – or move closer to the moving average. When the bands tighten up, traders will often use that formation as an early indication that the volatility is about to increase in the market they are watching.
Also, many traders will use the outer bands to signal possible reversals. In other words, if the bands are widening and price is hitting the top band – it could show an overbought condition. Conversely, if the bands are widening and the price hits the bottom band, it can often be a signal of an oversold condition. The indicator is thought of a “reversion to the mean” type of indicator when used like this as it is assumed that the markets will eventually go back to “normal conditions” when they have had a sharp move in one direction or another. As with many indicators, it can often be used in concert with others as it gives a visual representation of the overbought and oversold conditions that marketplaces experience on a regular basis that is easy to spot.
This is one of the most popular technical analysis techniques. The closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market.
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