Bollinger Bands are one of the most common volatility indicators used in technical stock market analysis. The bands plot three separate lines on a price chart, with the outer two representing a two-standard deviation range from a center line calculated using a simple moving average. Because the standard deviations widen or narrow dynamically based on the security's trading range, Bollinger Bands can be a very flexible and adaptable tool. It is very common to combine Bollinger Bands with another famous indicator, the Relative Strength Index, or RSI, to help confirm a trend's relative strength.
The RSI is a momentum indicator that compares the number of days a security closes up versus closing down over a period of time. These values are then plotted on a range from zero to 100, with overbought securities typically expected when the RSI returns a value over 70 and oversold securities expected when the value is under 30.
When the two are combined, the RSI acts to either support or dispel possible price trends. For example, if a stock price reaches the upper band of a Bollinger Band price channel and, at the same time, the RSI reads 70+, the trader could make the interpretation that the security is overbought. They could then sell the stock, buy a put or sell covered calls.
Suppose instead the price chart shows trading is reaching the lower Bollinger Band and the RSI is not under 30. In this case, the RSI is telling the investor the security may not be oversold as the Bollinger Bands seem to indicate. The trader would not immediately enter buy calls or purchase extra stock since the downtrend could continue. If the RSI is high enough, the trader may even consider a sell.
