Bollinger bands graphically show characteristics of price and volatility over time for a commodity or financial instrument to aid trading decisions.
A simple moving average takes a defined number of previous prices and removes the peaks and troughs over a period that the trader defines. Bollinger bands take the same idea and use it to determine the distance between the present price and the average, so you’ll see this moving average and then an additional couple of lines (the Bollinger bands) over and under it.
You can alter their level of offset by inputting whatever standard deviations from the mean you choose.
Terminology wise, if you see a (20, 2) setting, this refers to Bollinger bands that use a typical 20-period simple moving average and bands that are offset by two standard deviations from the mean. It shouldn’t be a problem in most trading software to play around with this setup, and change it to say, an exponential moving average.
Traders usually use Bollinger bands to indicate “reversion to the mean”. When the price is sitting below or above them Traders usually take this as a sign that it’s too low or too high respectively.
You’ll often see Bollinger bands used as an indicator of volatility, with a widening of them showing more of it and a narrowing meaning less, but not everyone uses the indicator as this sort of tool.
There are traders who think that if price strays beyond the bands but is still trending in the indicator’s general direction (and don’t forget that it’s just three distinct moving averages traveling side-by-side) then it’s seen as a trend following indicator.
But equally, you might choose to see Bollinger Bands as an indicator of volatility too. When there’s a ‘squeeze’ on, a term for when the market is less volatile, it could mean that a more volatile period is soon to follow it. And the opposite interpretation would be that when the bands are far apart then a less volatile stint could be on the way.
If you're a trader who is looking for a volatile or trending market then you’ll want to cut back on positions or close trades when the bands are diverging.
Bollinger bands are popular because they give traders a few different interpretation options.
There’s the “reversion to the mean” indicator which tells them if price has become overextended in either direction.
The trend-following indicator usage where movements on either side of the bands are seen as breakouts.
Finally, there’s the view that Bollinger bands show how volatile the market currently is. Narrow bands mean it’s less volatile but there is the potential for a breakout, and wide bands mean it’s more volatile and that it may be followed by a period that is more tranquil.