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Bollinger Bands Introduction

Bollinger Bands are used as an indicator to compare both volatility and relative price levels over a specific time period. The indicator is made up of three bands that are specifically designed to cover the majority of the price action of a security. The Bollinger Bands were created by market technician John Bollinger, who came up with the technique of using averages that move with to trading bands, as the Bollinger Bands add and subtract a calculation of standard deviation.

Standard deviation is a measuring mathematical formula that measures volatility and shows how the price of stock can spread around the stock’s “true value.” The technician looking at the bands can be pretty sure that all of the data for pricing can be found in between the two bands.

The Bollinger Bands are made up of a centerline and two price channels. One channel is above the centerline and another price channel below the centerline. The centerline is seen as an exponential moving average. The price channels are seen as standard deviations of the chart that is being studied by the person looking at the chart. The Bollinger Bands will expand and contract when the price action is volatile, expands, or is bound to a trading pattern that is tight, contracts.

It may be the case that a stock can trade for long time periods in a trend, but sometimes there will be some volatility. In order to see the trend better traders will use moving averages in order to filter the price action. By doing this the traders can get vital information in terms of discovering how the market is trading. For instance, after a major fall or rise in the trend, the market can consolidate, trading in a narrow way and crossing both above and below the average of the market. In order to look at this action traders will use price channels that are specifically designed to deal with all the trading activity around the trend.

Markets are erratic in their daily trading even though it is the case that they continue to trade in a trend that is upwards or downwards. Technicians, using lines of support and resistance, in order to anticipate the stock’s price action, use moving averages. Lower support lines and upper resistance lines are primarily drawn and then inferences are drawn to form channels. Within these channels there is an expectation by the trader that the prices will be contained.

There are traders that draw straight lines to connect the top or bottom of the prices in order to identify both the upper and lower price extremes. Then parallel lines are added in order to define the channel, where in the channel, the prices should move. If the prices do not move out of this channel the trader can know with a certain degree of confidence that the prices are moving as expected.

Traders are aware that when the price of the stock keeps touching the upper Bollinger Band that the price is seen to be over-bought. Conversely, when the price of the stock keeps touching the lower band the process are seen to be oversold, therefore a buy signal would be seen.