Bollinger Bands are a technical trading tool created by John Bollinger in the early 1980s. They arose from the need for adaptive trading bands and the observation that volatility was dynamic, not static as was widely believed at the time. The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions. Bollinger Bands consist of a set of three curves drawn in relation to securities prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, that serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes.
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For Bollinger Bands we have 15 rules:1. Bollinger Bands provide a relative definition of high and low.2. That relative definition can be used to compare price action and indicator to arrive at rigorous buy and sell decisions.3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc.4. Volatility and trend have already been deployed in the construction of Bollinger Bands, so their use for confirmation of price action is not recommended.5. The indicators used for confirmation should not be directly related to one another. Two indicators from the same category do not increase confirmation. Avoid colinearity.6. Bollinger Bands can also be used to clarify pure price patterns such as M-type; tops and W-type bottoms, momentum shifts, etc.7. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band. 8. Closes outside the Bollinger Bands can be continuation signals, not reversal signals--as is demonstrated by the use of Bollinger Bands in some very successful volatility-breakout systems.9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the bandwidth are just that, defaults. The actual parameters needed for any given market/task may be different.10. The average deployed should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.11. If the average is lengthened the number of standard deviations needs to be increased simultaneously; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced; from 2 at 20 periods, to 1.9 at 10 periods.12. Bollinger Bands are based upon a simple moving average. This is because a simple moving average is used in the standard deviation calculation and we wish to be logically consistent.13. Be careful about making statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The sample size in most deployments of Bollinger Bands is too small for statistical significance and the distributions involved are rarely normal. 14. Indicators can be normalized with %b, eliminating fixed thresholds in the process. 15. Finally, tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.
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