The Bollinger Bands indicator is a TA tool that measures market volatility and helps identify potential overbought or oversold conditions. They consist of three lines: a middle band, which is a simple moving average (SMA) of the closing prices over a set number of periods, typically 20 days, and two outer bands, calculated as the middle band plus minus two standard deviations (see image below).
Bollinger Bands are commonly used to spot potential overbought or oversold conditions. When the price breaks the lower band, it may indicate that the market is oversold and could be poised for a bounce. Conversely, a price surge above the upper band suggests the market may be overbought, signaling a possible correction.
The ability of Bollinger Bands to identify overbought or oversold conditions is based on the mean reversion theory. This theory states that prices tend to return to their average after deviating from it. In the context of Bollinger Bands, it implies that the price is likely to revert to the middle band after moving away from it.
Bollinger Bands can also be used with trading strategies, like the Bollinger Squeeze. The Bollinger Squeeze occurs when there's a shift from aggressive price movements to price consolidation. This change is indicated by the narrowing distance between the upper and lower bands, signifying reduced volatility (see image below). Following this consolidation phase, the price typically undergoes a significant directional move, which is what many traders aim to catch.
It’s important to note that Bollinger Bands also have limitations. As Bollinger Bands derive from a simple moving average, they assign equal importance to both recent and older prices, underestimating the impact of recent price data. In addition, the settings of a 20-day SMA and two standard deviations may not suit every market scenario. Some traders adjust these parameters often to fit their trading style and objectives.
Learn more: Bollinger Bands Explained.