Bollinger Bands—named for John Bollinger, their creator—are a lagging chart indicator that plots three lines:
- Simple Moving Average (SMA)
- An upper band that sits above the moving average
- A lower band that sits below the moving average
Both of the bands move in accordance with the standard deviation levels of the stock. The upper band is set at two standard deviations above the Simple Moving Average. The lower band is set at two standard deviations below the Simple Moving Average.
Bollinger Bands are are especially useful for determining when a stock is overbought or oversold as they are an envelope that follows the simple 14-day moving average of the stock and can encompass a wider range of price movement. When the price is at or above the upper band, the stock may be overbought. Conversely a price at, or below, the lower band, indicates that the stock may be oversold.
John Bollinger observed about his Bollinger Bands: Sharp price changes tend to occur as volatility lessens - after the bands tighten. When the stock price moves outside the bands, a continuation of the current trend is implied. A reversal of trend is usually indicated by bottoms and tops made outside the bands followed by bottoms and tops made inside the bands. Price targets can be predicted as a move that originates at one band tends to go all the way to the other band.
In Practice: Technical analysts use Bollinger bands to see how relatively high or low a stock is trading. When a stock gets close to the high or low band, an analyst will look for certain patterns, such as “double Bottoms” or "head and shoulders," which can indicate a stock is bottoming out or peaking. One is the double bottom, a classic bullish pattern. Another pattern to look for is called the "squeeze," where the Bollinger Bands contract and 'squeeze' the stock price, as can be seen in the chart below of
Candle Australia (CND) from January 2007. This represents a tightening in volatility and usually results in a release of pent-up price movement, typically to the upside.
