Bollinger Bands are a popular technical analysis tool created by John Bollinger. They're used to measure volatility and provide insight into potential market direction. Bollinger Bands consist of three lines: the middle band (a simple moving average), and two outer bands, which are standard deviations away from the middle band.
Here's a simple explanation of how Bollinger Bands work, how to use them, and an example to illustrate:
### How Bollinger Bands Work:
1. **Middle Band**: This is a Simple Moving Average (SMA) of a specific period, usually 20 days. It gives you the average price over the given time frame.
2. **Upper Band**: This is calculated by adding two standard deviations to the middle band. Standard deviation measures how spread out the prices are from the average, so the upper band shows a price level that's higher than usual.
3. **Lower Band**: This is calculated by subtracting two standard deviations from the middle band. Like the upper band, it shows a price level that's lower than usual.
### How to Use Bollinger Bands:
1. **Identifying Overbought or Oversold Conditions**:
- **Overbought**: If the price reaches or crosses the upper band, it may be considered overbought, and a reversal might be near.
- **Oversold**: If the price reaches or crosses the lower band, it may be considered oversold, and a reversal to the upside might be near.
2. **Trend Identification**:
- **Upward Trend**: If the price is consistently near the upper band, it might be in an upward trend.
- **Downward Trend**: If the price is consistently near the lower band, it might be in a downward trend.
3. **Squeeze and Expansion**:
- **Squeeze**: If the bands come close together (squeeze), it may indicate a period of low volatility and a potential breakout.
- **Expansion**: If the bands widen (expand), it may indicate increased volatility and a strong trend.
### Example:
Imagine a stock with the following characteristics:
- Middle Band (20-day SMA): $100
- Upper Band: $110
- Lower Band: $90
You might interpret this as follows:
- If the stock's price rises to $110 or above, it may be considered overbought, and you might look for sell signals.
- If the stock's price drops to $90 or below, it may be considered oversold, and you might look for buy signals.
- If the bands suddenly squeeze or expand, you might look for signs of a breakout or strong trend.
Remember, Bollinger Bands are just one tool and should be used with other indicators and analyses for more accurate trading decisions. No indicator is foolproof, and practicing with historical data or in a demo account can help you understand how to best use Bollinger Bands in your specific trading strategy.