How do you measure the volatility in the market? Price volatility in the market is mostly measured with the standard deviation. Bollinger bands are technical indicators that plot the standard deviation of the price action. Two bands are plotted. One above and the other below the moving average. The period of the moving average is 20 mostly as this time period effectively represents the intermediate trend.
Bollinger bands may be applied to any market or security. Any timeframes from daily, weekly, monthly to intraday can be used. Primary advantage of using these bands is to check if the prices are relatively low or high
Bands will be narrow when the volatility in the market is low. These bands expand when the volatility in the market increases. This information can be especially useful to options traders as options prices are heavily influenced by the swings in volatility.
When prices move above the upper band this is a sign of great strength and when they move below the lower band, a sign of great weakness. When prices move outside the bands, trend continuation is often a valid assumption.
When the bands happen to tighten as they do when the volatility in the market decreases, rapid and substantial price moves often take place after the band tightens. This is something an experienced trader always keeps in mind. Now, Bollinger Bands are mostly used in conjunction with other technical indicators like the Commodity Channel Index (CCI), Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI) and others.
Now the recommended setting for these bands is two standard deviations above and below the moving average with the period 20. These bands will keep on moving close or away from the moving average as a function of the market volatility.
But sometimes, you want to trade a longer timeframe. In that case, 50 is usually used as the period for the moving average with longer trends and the standard deviation settings for the two bands should be increased to two and half standard deviations. In case of very short timeframes, the moving average period should be lowered to 10 and the standard deviation should also be decreased to one and a half for the two bands.
Trading these bands is one of the most powerful concepts that is available to any trader whethet stocks, futures, forex, options or commodities. As said before, these bands are traded in conjunction with other technical indicators. In case of the stock market, a period of 20 for the moving average is okay.
Now these bands do not provide absolute signals when prices touch these bands. These signals should only be taken as relative and confirmed in conjunction with other technical indicators.
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