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Bollinger bands are indicators used when trading stocks using a technical analysis approach. Technical analysis is an approach to investing in the market that attempts to use a disciplined market timing approach. Bollinger bands were developed by John Bollinger in the 1980s.
Technical analysis approaches involve computing moving averages of the stock in interest. A moving average is simply an average that is computed over a period of time and repeated as time progresses. A typical moving average is the seven day moving average, computed by adding the price of the stock over the past seven trading days and dividing the result by seven. A day later, the average is again computed, but the price from the first day is dropped and the day two price becomes the day one price. This is repeated each day until the original day seven price is replaced. This process is repeated each trading day, and the results can be plotted as average stock price versus time.
Using the same data set from which the average is calculated, a standard deviation series for the same data set can be calculated. Two more lines are plotted on the chart, the first showing the average plus one standard deviation, and the second showing the average minus one standard deviation. These two lines are called Bollinger bands. The average plus one standard deviation is the upper Bollinger band and the average minus one standard deviation is the lower Bollinger band. There are now four lines on the chart: the daily stock price, the moving average, and the upper and lower Bollinger bands.
Technical traders use this information to determine trading signals. If stock prices approach upper Bollinger bands, the stocks are thought to be in their high price range. If stocks approach lower Bollinger bands, then they are said to be in their lower trading range. If the stock price were to break outside of either of the Bollinger bands then a significant move in the stock price is expected. John Bollinger, who came up with the Bollinger Bands concept, is now a financial commentator with CNBC and maintains a site on the Internet with much more information about his theories and concepts regarding Bollinger bands.
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