For a bullish event to generate, the price needs to close more than two standard deviations below that of the 20 period moving average of price. On the other hand, a bearish event will occur when the prices close more than two standard deviations above. When a price over-extension leads to the promise of a reversal, we consider this a Bollinger band. At times, Bollinger bands may need secondary inputs to be validated such as RSI.
Founded and named after John Bollinger, Bollinger bands were actually one of the first adaptive tools for volatility envelope. For years before, fixed percentage envelopes were being drawn below and above the moving average but Bollinger bands were introduced; instead, these were calculated using the closing price standard deviation of an instrument.
For the benefit of traders, Bollinger bands consider both simple moving averages as well as standard deviation in order to make a decision on buying or selling events. In such case, four lines are displayed including the lower and upper Bollinger bands, the moving average and the price. Normally, the 20-day moving average will show two standard deviations below the lower and upper Bollinger bands and we consider these settings to be acceptable. When looking over a shorter time period, some experts may choose to bring this down by 1/2 to 1 1/2 standard deviations with the moving average at ten days. On the other hand, a longer-term trend may require an increase of 1/2 standard deviation with a moving average of 50 days.
Ultimately, the Bollinger bands were introduced to give an indication of low and high price range. According to the theory, the lower band will see lower prices and vice versa. Over time, the price will fluctuate between the two bands with penetrations being tradable. If the bands contract or expand around the moving average, this will lead to low or high volatility respectively.
Trading Considerations - Normally, Bollinger bands will be used in conjunction with other trading strategies. After the Bollinger band penetration, these techniques can then be used to monitor the price action. When tracking downside or upside momentum, many traders choose to look for a number of touches before acting.