Bollinger Bands is a versatile tool combining moving averages and standard deviations and is one of the most popular technical analysis tools available for traders. There are three components to the Bollinger Band indicator :
- Moving Average: By default, a 20-period simple moving average is used.
- Upper Band: The upper band is usually 2 standard deviations (calculated from 20-periods of closing data) above the moving average.
- Lower Band: The lower band is usually 2 standard deviations below the moving average.
Playing the Bollinger Bands
Playing the bands is based on the premise that the vast majority of all closing prices should be between the Bollinger Bands. That stated, then a stock's price going outside the Bollinger Bands, which occurs very rarely, should not last and should "revert back to the mean", which generally means the 20-period simple moving average. A version of this strategy is discussed in the book Trade Like a Hedge Fund by James Altucher.
Buy Signal
In the example shown in the chart below of the E-mini S&P 500 Future, a trader buys or buys to cover when the price has fallen below the lower Bollinger Band.
Sell Signal
The sell or buy to cover exit is initiated when the stock, future, or currency price pierces outside the upper Bollinger Band.
These buy and sell signals are graphically represented in the chart of the E-mini S&P 500 Futures contract shown below:
