Developed by John Bollinger, the Bollinger Band shows the price of the stock with an upper and lower band (standard deviation) shown with a 21-day simple moving average.
Standard Deviation is a model of volatility.
- larger volatility is presented with a larger band (more room for growth, but equally for loss)
- smaller band means less volatile.
Oversold & Overbought
Some people believe that:
- as the price of the stock moves to the upper band == Overbought
- the more it moves to the lower band == Oversold
The Squeeze
When the bands contract, this is called a squeeze.
- period of lower volatility
- many take as a signal for future increased volatility and trading
When the bands move further apart
- larger risk for them to move apart again
- may be a good time to exit a trade.
These conditions are not trading signals. They don’t indicate when the change will take place, or the direction they’ll move.
The math
Bollinger Bands consist of:
- an N-period moving average (MA)
- an upper band at K times an N-period standard deviation above the moving average (MA + Kσ)
- a lower band at K times an N-period standard deviation below the moving average (MA − Kσ)
N and K are usually 20 and 2.
Other averages can be used, such as the exponential moving average.
Effectiveness
A 2007 study that spanned from 1995 to 2005 showed no evidence of consistent performance over the standard “buy and hold” approach, but a “contrarian Bollinger Band” (reversal of the strategy) yielded positive results.
The band may be more effective in Chinese markets.