Bollinger Bands are one of the most commonly used chart indicators available today in the markets. But while many traders will plot these readings on their charts, few actually know how these visuals are calculated. it is a major newbie mistake to start using an indicator when you know nothing about its calculations because real money is being put at risk. If you misunderstand how a chart indicator is truly meant to be used, you might set up a trade in the wrong direction and unnecessarily damage your trading account balance. Mistakes like these are clearly avoidable with a little research into what the indicators are meant to show you.
When trying to understand Bollinger Bands, first we will need to define the term. The Bollinger Band is a widely popular and commonly used technical analysis tool that was invented by John Bollinger several decades ago. The concept that was developed by Bollinger and evolved from the idea of trading bands, which are meant to give traders a sense of how high or low the current price is, relative to historical averages. Here is a visual representation of the key components of the Bollinger Band:
Bollinger Bands are comprised of:
? an N period historical moving average (generally abbreviated as MA)
? an upper trading band calculated by multiplying K by an N period standard deviation (SD) which is plotted above the MA, seen in in the equation (MA + Ks)
? a lower trading band calculated by multiplying K by an N period standard deviation (SD) which is plotted below the MA, seen in in the equation (MA – Ks)
Generally, the common values that are used for N and K will be 20 and 2. In addition to this, most trading stations will use a simple moving average as the default setting but this can be customized to meet your trading plan if you wish to make any changes. Other options include an Exponential Moving Average (EMA). The default settings will also usually implement the same time period to determine the middle Bollinger Band as well as the calculated standard deviation.
The Purpose of Bollinger Bands
“While, for some, the mathematical calculations might seem daunting,” said Rick Bartlett, currency analyst at CornerTrader , “you can rest assured that this is all there is to understanding the calculations and no further advanced math will be used in this explanation.” At this stage, you can turn your focus to the purpose of the Bollinger band calculation so that these can be used to identify trading signals when they develop. At its essence, the Bollinger Band calculation is meant to give traders a relative idea of the potential highs and lows for a currency pair. When prices approach the upper band, traders will generally start to view the pair as though it is reaching its high. When prices approach the lower band, traders will generally start to view the pair as though it is reaching its low. For these reasons, Bollinger Bands are used in many commonly used pattern recognition software applications as they can give a sense of when a rally or decline is coming to an end and is ready to reverse.