What is a 'Bollinger Band®'
A Bollinger Band®, developed by famous technical trader John Bollinger, is plotted two standard deviations away from a simple moving average.
In this example of Bollinger Bands®, the price of the stock is bracketed by an upper and lower band along with a 21-day simple moving average. Because standard deviation is a measure of volatility, when the markets become more volatile, the bands widen; during less volatile periods, the bands contract.
BREAKING DOWN 'Bollinger Band®'
Bollinger Bands® are a highly popular technical analysis technique. Many traders believe 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. John Bollinger has a set of 22 rules to follow when using the bands as a trading system.
Want to know more? Read The Basics of Bollinger Bands
The squeeze is the central concept of Bollinger Bands®. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities. Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or which direction price could move.
Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event. The breakout is not a trading signal. The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.
Not a Standalone System
Bollinger Bands® are not a standalone trading system. They are simply one indicator designed to provide traders with information regarding price volatility. John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals. He believes it is crucial to use indicators based on different types of data. Some of his favored technical techniques are moving average divergence/convergence (MACD), on-balance volume and relative strength index (RSI).
The bottom line is that Bollinger Bands® are designed to discover opportunities that give investors a higher probability of success.