What it is:
Bollinger Bands are used as a technical analysis indicator. They are formed by using a 20-day moving average as a centerline and then tracing two bands, each one standard deviation wide, on either side of the moving average. By watching the share price's interaction with these bands, technical analysts try to forecast price movements.
How it works (Example):
Bollinger Bands are named after John Bollinger -- a well-known commentator and technical analyst. Bollinger built his work on a foundation laid by an influential researcher named Hurst, who discussed "trading envelopes." Hurst put these so-called "envelopes" around a stock (or index), surrounding it with a fixed percentage -- such as 3% or 4%. He noted that trading opportunities often arose when the stock reached one end of the envelope and then began to reverse.
When a stock moves outside the upper-end of a Bollinger Band, it is considered "overbought." In other words, it has gone up too far, too fast. Such stocks are often vulnerable to profit taking. Conversely, when a stock drops below the lower band, it is considered "oversold." An oversold stock has gone down too far, too fast. These stocks often bounce higher when bargain-hunters jump in and purchase the shares
Traders often rely on several major principles related to Bollinger Bands:
1. The bottom or top of the band is likely to provide support or resistance, just like a "horizontal" support or resistance level. In many cases, support or resistance can also be found at the 20-period moving average, which marks the center of the band.
2. If a stock continues to close outside the band, this is a continuation signal. In other words, the shares are likely to continue trading in the same direction.
3. When a particular stock reverses after closing outside the band, it often retreats to the opposite band before finding support.
4. A narrowing of the bands suggests that the next move will be a volatile one. Swing traders should watch a stock with narrow bands carefully to identify the breakout from resistance or breakdown from support. This breakout or breakdown can often yield a profitable trade.
5. Prices can often "ride" the band. Riding an upper band indicates strength; riding the lower band shows weakness.
The chart below illustrates several Bollinger Band principles. Note that for much of the uptrend, prices rode the upper band. Next, the stock went from outside the upper band to outside the lower band. It also closed outside the lower band -- a continuation signal.
Why it Matters:
Bollinger Bands are an important technical tool for the trader that can help refine judgments based on classical technical analysis and indicators. When analyzing a chart, the five principles described above should be carefully applied. If used correctly, Bollinger Bands could tell a swing trader when he or she should buy or sell a particular security.