Bollinger Bands are widely used by professional traders and fund managers, and are designed to answer the question whether the price of a stock or index is high or low on a relative basis. Armed with this information, traders can make buy and sell decisions by using additional technical indicators to confirm price action of the stock or index they are trading. The Bollinger band does not give absolute buy and sell signals simply by having been touched; rather, it provides a framework within which price may be related to other technical indicators.
Bollinger Bands are formed by calculating two standard deviations around a 20 day simple moving average of an underlying index or stock. Two standard deviations include about 95% of the chart’s price data between the two trading bands. Because the standard deviation calculation is based on volatility, as the stock or index’s volatility changes the width of the “envelope” will increase or decrease correspondingly.
Below is a chart of the DOW with its 20, 50, 100 and 200 day simple moving averages along with its Bollinger Bands (pink lines). The 20 day simple moving average is the thin blue line, which is the center point of the Bollinger envelope. Note how the width of the envelope opens and closes as volatility of this index changes. (when an index goes down, volatility usually increases) The main observation of this chart is that the DOW dropped by more than 390 points on the last trading day shown and it touched the bottom band. Therefore, on a relative basis, we know that the DOW index is low and some traders/professional money managers, after looking at additional technical indicators, might conclude that the DOW is oversold and is ready for a Bullish reversal – and at this point they might decide to open a Bullish trade.