The Bollinger bands were first created by an experienced technician in the markets. Bollinger bands were developed using a technique that applies moving averages along with two trading bands placed above and below the moving average. These bands are formed by simply adding or subtracting the standard deviation from the calculation instead of calculating the normal moving average.
How to Calculate Bollinger Bands?
The standard deviation is a statistical calculation that provides an insight into the volatility of the stock and how it can vary from its true value. As a result, Bollinger bands can be considered as most suitable to get an insight into the market conditions by constantly adjusting themselves according to the measured volatility in price.
The Bollinger bands are very useful to any trader as all the price data is clearly available between these two bands. Here is some information about how this indicator works, how to calculate it and how to use it for trading.
Understanding Bollinger bands
The Bollinger bands include two price channels located above and below the center line. The center line in the Bollinger bands is nothing but the exponential moving average, and the price channels are the standard deviations of the stock that is being studied. These bands will expand whenever the price of a commodity becomes volatile. Similarly when there is a strong trading pattern, the band will contract.
Stocks often move in a trend with little volatility from time to time. To better understand these trends, the traders often uses moving averages to filter the price action. This allows the traders to learn about important information pertaining to how the stock has been trading in the market. The markets often consolidate after a sharp trend of rise and fall. As a result, the investors start trading in a very narrow fashion by making bids slightly above and below the moving average. To monitor this particular behavior in a more organized manner, the traders use certain price channels encompassing the activity around the trend.
When the stock prices are constantly in the upper region of the Bollinger Band, the prices are assumed to be overbought. Similarly, when they touch the lower band, the prices are assumed to be oversold. This triggers a buy signal in the market. The Bollinger bands also indicate a change in trend. The upper and the lower bands are considered to be price targets in the market. When the price moves off the lower band and crosses the 20 day moving average, the upper band is considered to be the price target. During this situation, if the price moves below the 20 day moving average, it is a clear indication of a reversal in the trend.
Calculating Bollinger Bands
Bollinger Bands are calculated using moving averages. Once you have the moving average, the standard deviation of the closing price is calculated over the same period as that of the moving average. This standard deviation is then multiplied by the a factor, which is normally 2. Once you have finished this calculation, you will have to obtain the upper and the lower bands. The upper band is calculated by adding standard deviation that has been multiplied by the suitable factor to the available moving average. The lower band in the Bollinger Bands is calculated by subtracting the standard deviation which has been multiplied by a suitable factor from the available moving average.
The DJIA is usually calculated with either the 20 or 21 day moving averages along with the percentages in the range of 3.5 to 4.0 to obtain the upper as well as the lower Bollinger Bands. The 20 day simple moving average is calculated by using the closing prices of the past 20 days and finding the arithmetic average of these values. To calculate the standard deviation, subtract the simple moving average from each of the closing values and square the same. The squares obtained are then added and another arithmetic average is obtained. The square root of this average itself is the standard deviation.
To calculate the upper band, simple add the moving average to the product of standard deviation and the chosen factor (preferably 2) and for the lower Bollinger band, subtract the product of the factor and the standard deviation from the moving average. Plotting these three values in an extrapolated manner will provide you with the indicator known as Bollinger Bands.