Bollinger Bands
Developed by John Bollinger, Bollinger Bands allows users to compare volatility and relative price levels over a period time. Bollinger Bands are envelopes which surround the price bars on a chart. They are plotted two standard deviations away from a simple moving average. Because standard deviation is a measure of volatility, the bands adjust themselves to ongoing market conditions. They widen during volatile market periods and contract during less volatile periods. Bollinger Bands are, essentially, moving standard deviation bands.
Bollinger Bands are sometimes displayed with a third center line. This is the simple moving average line. Mr. Bollinger recommends using a 10 day moving average for short term trading, 20 days for intermediate term trading, and 50 days for longer term trading.
The standard deviation value may be varied. Increase the value from 2 standard deviations to 2-1/2 standard deviations away from the moving average when using a 50 day moving average. Conversely, lower the value from 2 to 1-1/2 standard deviations away from the moving average when using a 10 day moving average.
Bollinger Bands do not generate buy and sell signals alone. They should be used with another indicator such as Relative Strength (RSI). This is because when price touches one of the bands, it could indicate one of two things. It could indicate a continuation of the trend; or it could indicate a reaction the other way. By themselves they do not tell us when to buy and sell.
However, when combined with RSI, they become powerful. RSI is an excellent indicator with respect to overbought and oversold conditions. When price touches the upper band, and RSI is below 70, we have an indication that the trend will continue. When price touches the lower band, and RSI is above 30, we have an indication that the trend will continue.
If we run into a situation where price touches the upper band and RSI is above 70 approaching 80 we have an indication that the trend may reverse itself and move downward. On the other hand, if price touches the lower band and RSI is below 30 approaching 20 we have an indication that the trend may reverse itself and move upward.
While there are many ways to use Bollinger Bands, following are a few rules that serve as a good beginning point.
1. Bollinger Bands provide a relative definition of high and low.
2. The indicators used should not be directly related to one another. For example, you might use one momentum indicator and one volume indicator.
3. Bollinger Bands can also be used to clarify pure price patterns such as "M" tops and "W" bottoms, momentum shifts, etc.
Price can, and does, walk up the top Band and down the bottom Band.
4. Closes outside the Bollinger Bands are continuation signals, not reversal signals. This has been the basis for many successful breakout systems.
5. tags of the bands are just that, tags not signals. Touching the upper band is NOT in-and-of-itself a sell signal and touching the lower band is NOT in-and-of-itself a buy signal.
6. this indicator consists of three bands encompassing a security's price action. Defaults are:
A simple moving average in the middle, usually 20 days for intermediate investing.
An upper band ( 20 day SMA plus 2 standard deviations)
A lower band (20 day SMA minus 2 standard deviations)
Standard deviation is a statistical term that provides a good indication of volatility. Using it ensures the bands will react quickly to price movements and reflect periods of high and low volatility. Sharp price changes and hence volatility, will lead to a widening of the bands.
7. Double bottom buy (W): A double bottom buy signal is given when prices penetrate the lower band and remain above the lower band after a subsequent low forms. Either low can be higher or lower than the other. The important thing is that the second low remains above the lower band. The bullish setup is confirmed when the price moves above the middle simple moving average.
Double top sell (M): A sell signal is given when prices peak above the upper band and a subsequent peak fails to break above the upper band. The bearish setup is confirmed when prices decline below the middle band.
8. By themselves, Bollinger Bands serve two primary functions:
To identify periods of high and low volatility
To identify periods when prices are at extreme, and possibly unsustainable, levels.
9. Bollinger Bands are useful for determining whether current values of a data field are behaving normally or breaking out in a new direction. For example, when the closing price of a security increases above its upper Bollinger Band, it will typically increase in that direction.
10. Bollinger Bands can also be used for identifying when trend reversals may occur. New highs or lows outside of the bands
followed by another high/low inside of the bands typically indicates a reversal in the current trend.
This is how the bolliner bands applied to the price action.
There is lot more threads in Traderji on bollinger bands. Two i found best are one by Columbus sir dedicated to Bollinger bands. And other by linkin sir, in his DB BB system. Here are the links to the threads.
http://www.traderji.com/day-trading/27421-bollingerbands.html
http://www.traderji.com/day-trading/37079-linkons-db-bb-system.html