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.

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

Creating Bollinger bands

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. Without getting into too much detail, the distance of the bands from ...

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