The Bollinger Bands

Introduced by John Bollinger in the 1980s, Bollinger bands (BB) is perhaps one of

the most useful indicators used in technical analysis. BB are used to determine

overbought and oversold levels, where a trader will try to sell when the price

reaches the top of the band and will execute a buy when the price reaches the

bottom of the band.

The BB has 3 components:

1. Middle line which is The 20 day simple moving average of the closing prices

2. An upper band – this is the +2 standard deviation of the middle line

3. A lower band – this is the -2 standard deviation of the middle line

The standard deviation (SD) is a statistical concept; which measures the variance of

a particular variable from its average. In finance, the standard deviation of the stock

price represents the volatility of a stock. For example, if the standard deviation of a

stock is 12%, it is as good as saying that the volatility of the stock is 12%.

In BB, the standard deviation is applied on the 20 day SMA. The upper band

indicates the +2 SD. By using a +2 SD, we simply multiply the SD by 2, and add it to

the average.

For example if the 20 day SMA is 7800, and the SD is 75 (or 0.96%), then the +2 SD

would be 7800 + (75*2) = 7950. Likewise, a -2 SD indicates we multiply the SD by 2,

and subtract it from the average. 7800 – (2*75) = 7650.

We now have the components of the BB:

1. 20 day SMA = 7800

2. Upper band = 7950

3. Lower band = 7650

Statistically speaking, the current market price should hover around the average

price of 7800. However, if the current market price is around 7950, then it is

considered expensive with respect to the average, hence one should look at

shorting opportunities with an expectation that the price will scale back to its

average price.

Therefore the trade would be to sell at 7950, with a target of 7800.

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