# Bollinger Bands

**Topic Progress:**

After this lesson you will know:

- How
**Bollinger Bands**are calculated, - How this calculation
**can best be used,**and - What the
**wisdom about Over-Bought and Over-Sold**markets is.

*Reading time: 15 minutes*

## What are Bollinger Bands and why are they important?

Bollinger Bands are technical analysis indicators and show the relative bandwidth of the current price compared to the previous price. The Bands are used as indicators of trends because they primarily reflect the volatility of the underlying asset.

**In other words:** The Bollinger Bands (orange) are two standard deviations from the simple average (black) and show the probable trend of price development.

## A Bollinger Band is made of these parts

The Bollinger Bands always consist of three different lines, which are listed in the bands specification. Such specification provides an example as follows:

*BB(20,2,2)*

*20*

The first number in this specification tells you how many units of time are included in calculating the average. This average is a “simple” average. A simple average of the five numbers (2, 4, 7, 3, 1) is calculated as follows:

The sum of 2, 4, 7, 3 and 1 is 17. This figure is then divided by the total amount of number (5) which gives you an average of 3.4.

With the Bollinger Band, the average is always taken from the closing price of the last 20 time units.

*2,2*

The second and third numbers are related, which is why the specification also sometimes provides only ONE second indication. This represents the number of standard deviations upwards and downwards.

Accordingly, two standard deviations are added to the average value and two standard deviations are subtracted.

## Standard deviation determines the bandwidth

Standard deviation has many different names on the financial market such as: risk, fluctuation, volatility, etc. In their calculation, it always remains the same:

It measures the absolute distance of the respective closing prices from the average and creates an average line for this.

By adding or subtracting this standard deviation from the average, the subsequent range displays in which the price is likely to move.

## What should Bollinger Bands be used for?

Bollinger Bands are an excellent way to channel a trend. Bands allow traders to see if the price is following a specific band or trend, if it has broken a band or if it’s beginning to flatten out and extend sideways.

**One Important Point!** The experienced trader never relies on a single Bollinger Bands alone. Traders should always use another indicator, this can also be another Bollinger Band with a different standard deviation.

**Example**

In the graph two Bollinger Bands with different standard deviations are combined. The first “Band” is the default with a standard deviation of two (chart in orange) the second Bollinger Band has a standard deviation of one (chart in light blue).

You can clearly see that the price movement stays between the bands.

## The “Fairy Tale” of Over-Bought and Over-Sold markets

On the financial market there are many sayings, this is one of the most well-known:

Over-Bought market when reaching the upper Bollinger Band or the inverse, an Over-Sold market when reaching the lower of the Bollinger Band.

*Christopher Scharl: Übergekaufter Markt bei Erreichen des oberen Bollinger Bandes beziehungsweise sein Gegensatz des überverkauften Marktes bei Erreichen des unteren Bollinger Bandes.*

**Explanation of Terms**

An Over-Bought market has a price history that shows a number of strong gains and the market appears to be saturated. In such a phase, market participants tend to take profits and sell their positions. The result would be a change of course and thus falling prices.

The Over-Sold market is the exact opposite of an Over-Bought market, here there was a series of heavy losses, as a result of a variety sold positions. This usually causes a backlash, and the price gains parts of these losses back.

**There is no truth to this alleged wisdom!**

The two terms “Over-Sold” or “Over-Bought” would imply that a “Price-Correction” should occur. However, in reality, the breaking of a Bollinger Band generally leads to the continuation of the current price trend.

In the chart we can see the continuation of the downward trend after the Bollinger Band was broken, although the “Wisdom” would say that the prices should rise.

## How to detect the start of trend

Bollinger Bands are very well suited to detect the beginning of a trend. Once the Bollinger Bands contract, that is the space between them gets smaller, this shows a flattening of the price and a decrease in variation.

This is generally a short-term state, which is typically followed by an upward or downward price trend. Normally, a band width that is less than 3.5% of the current share price is a good sign that a new trend is about to start. The range of Bollinger bands is calculated by the spacing at points between the upper and lower band.

In the chart, we can see that when the price flattens out and there are only small price movements, the Bollinger Bands contract.

The red circle indicates the early signs that a trend is about to start. The price jumps in both directions trying to break the bands. The price trend continues as soon as the band has been broken.