Most of us have heard about Bollinger Bands as one of the commonly used indicators especially for daily trader. Do we really understand how Bollinger Bands works?
Bollinger Bands is developed by John Bollinger in the early 1980s. Basically, it just a band plotted two standard deviations away from a simple moving average. The purpose of this indicator is to provide a relative definition of high and low. Standard deviation is just a statistical unit of measure of price volatility.
Prices are high at the upper band and low at the lower band. We can say the the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. But we need to remember that it doesn't mean that we should buy when the prices reach the lower band (oversold) or we should sell when the prices reach the upper band (overbought).
When I use Bollinger Band, I would like to identify the periods of high and low volatility. When the markets become more volatile, the bands widen, and during less volatile periods, the bands contract. The contraction of the bands is often used by technical traders as an early indication that the volatility is about to increase sharply.
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