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.
Now, prices can be within the band or outside the band. When prices are outside the bands, this is taken as a signal that the trend is most likely to continue. When prices are above the upper band, this is taken as a sign of strength in the market. However, when the prices are below the lower band, this is taken as a sign of weakness in the market.
Rapid and substantial price moves often tend to happen after the band tightens. Bollinger bands are often used in conjunction with other technical indicators to detect high probability trend reversal or turning points. The primary indicator that works best with these bands is the RSI (Relative Strength Index), MACD or the CCI ( Commodity Channel Index).
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.
However, when prices touch these bands, it should never be taken as an absolute signal. It should only be taken on a relative basis and the price action needs to be confirmed with other technical indicators before trading on these signals.