Bollinger bands saw its inception back in the late 20th century when John Bollinger – the creator of Bollinger bands – found a way to predict the changes in the short-term security market.
What exactly are Bollinger bands?
In the simplest of terms, Bollinger Bands is a graph that helps investors in predicting the fluctuations in the prices of securities hold in the near future. As the name indicates, the graph is based on two bands – called trading bands. There is a higher trading band and a lower trading band on the graph, both of which are plotted by taking into account the average of a pre-determined number of prices.
How does it work?
To understand Bollinger Bands, it is important that you know the concepts of moving average and volatility.
Moving average is an indicator that is concerned with smoothing out the random fluctuations in a price of security. It helps in providing you a stable average based on the prices in the past.
Volatility and standard deviation are inter-related. Basically it is the rate with which the security prices increase or decrease within a particular set of returns (time periods).
Now that you briefly understand these concepts, it will be easier for you to understand how Bollinger Bands work. Since the trading bands in this graph are based on the standard deviation, they are highly concerned with the volatility of prices in the past.
When the market is running smoothly, the price of a particular security will always remain between the bands. This means that there is very little fluctuation in the rate with which these securities are bought and sold. The bands in this case come close to each other. This process id called contraction.
On the other hand, if the market is more volatile, then these bands will move away from the simple moving average – denoted by a central line within the trading bands. This process is called the expansion.
How do I read Bollinger Bands?
One of the most basic tricks of reading the Bollinger bands is watching out for the different periods of volatility. When the trading bands come very close to each other (contraction) and consequently close to the moving average, it is for a fact then that the near future of the security will see an expansion.
In other words, if the Bollinger Bands start coming closer to each other, it is a sign that they will move away from each other very soon. This means that there would be a window of opportunity for trading the share. Remember that a Bollinger Band only represents a particular set of shares issued by a company, which means that every set of shares has its own Bollinger Band.
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