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What are Bollinger bands?
Bollinger bands are a popular form of technical price indicator. They are made up of an upper and lower band, set either side of a simple moving average (SMA). Each band is plotted two standard deviations away from the SMA of the market, and they are capable of highlighting areas of support and resistance.
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How to calculate Bollinger bands
Bollinger bands are calculated using three lines drawn onto a price chart. The first line is the SMA of an assets's price, usually within a 20-day period. The upper band is the SMA plus two standard deviations, while the lower band is the SMA minus two standard deviations.
To calculate the SMA, you would take the closing prices for the number of days that you were looking at – normally 20 days – and divide the total sum of all the closing prices by the total number of days.
Once you have the SMA, you can calculate the upper and lower bands:
- The upper band = 20-day simple moving average plus (20-day standard deviation multiplied by 2)
- The lower band = 20-day simple moving average minus (20-day standard deviation multiplied by 2)
Most trading platforms will calculate Bollinger bands for you automatically, but it is still useful for a trader to know what the different bands mean and what can be learnt from them.
What do Bollinger bands tell traders?
Many traders believe that Bollinger bands are an accurate indicator of market volatility. If the bands are wider, it means that a market is more volatile; while narrower bands mean that a market is more stable.
Traders also look for Bollinger ‘squeezes’ and Bollinger ‘bounces’, which are used as indicators for levels of support and resistance. Squeezes – when the upper and lower band contract toward the moving average – could show that there is about to be a breakout of the asset’s price. Conversely, bounces – which occur when the price movement hits the upper band and bounces back down – might be indicative of an upcoming retracement.
However, just like other indicators, Bollinger bands are not always 100% accurate. The information they provide should be used in conjunction with other forms of analysis.
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Pros and cons of Bollinger bands
Pros of Bollinger bands
Bollinger bands can be useful indicators of a trend in a market – strong trends cause volatility, which is easy to see as the Bollinger bands widen and narrow.
When plotted automatically by a trading platform, Bollinger bands are very user-friendly and can add another dimension to chart analysis for a trader.
Cons of Bollinger bands
As a lagging indicator, Bollinger bands can’t predict price patterns but instead, they follow current market movements. This means that traders might not receive signals until the price movement is already underway.
It is also worth noting that John Bollinger – the man who invented Bollinger bands – has said that they should be used in conjunction with other forms of technical analysis and that they are not fool-proof or fail-safe indicators of market trends.
More about Bollinger bands
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