Bollinger Bands

The Bollinger band indicator consists of three lines: the upper, the lower and the Simple Moving Average (SMA) that is between the two. The upper/lower bands are plotted two Standard Deviations away from a SMA. Standard deviation is a measure of Volatility; therefore, Bollinger bands adjust themselves to market conditions. When the markets become more volatile, the bands widen, and they contract during less volatile periods.

The closer the prices move to the upper band, the more overbought the Stock is. The closer the prices move to the lower band, the more oversold the stock is. Below is an example using General Electric (GE). Bollinger bands are blue for the lower band, green for the average and red for the upper band:


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We have circled three key points on this chart. The blue circle is where the stock price started to create a "base" on the lower band - it appeared that the stock was oversold. Buying at this point would have been a wise choice, as the stock proceeded to jump 20% or more in the next few weeks.

The two red circles are areas where the stock price was touching or breaking through the upper red band. This is usually an indication that the stock is overbought. In both instances, the stock dropped substantially in subsequent weeks.

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