Buddying up with Bollinger Bands

The idea behind Bollinger bands is that when a price for a security gets too high above or below a moving average, that security may be considered overbought or oversold. Bollinger bands look just like moving averages on a price chart (see "Utilizing Moving Averages," earlier in the chapter), but they're positioned a certain distance above and below the real moving average on a chart. The bands mark the areas where a security may be considered overbought or oversold.

You may do well to leave the necessary calculations of Bollinger bands to a charting package, but it starts out simple enough with the calculation of a simple moving average of a price series. (Find that process in this chapter's "Using simple moving averages" section.) Bollinger suggests a 20-day moving average, and many charting software programs use that as the default, so that's always a good place to start.

After calculating the 20-day moving average, things get a bit trickier. The bands that run above and below the moving average are based on a statistical measure known as standard deviation. The bands are placed a certain number of standard deviations higher and lower than the moving average.

Bollinger bands received their name from the renowned technical analyst John Bollinger.

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