These indicators are derived from moving averages and aim at
filling in an important gap. Indeed, moving averages give buying and selling
signals at punctual levels, which can thus quickly be invalidated should the
market reverse on the very short term (during the session or from a session to
another).
It can thus be wise, rather than defining precise
thresholds, to use zones defined as intervals on both sides of the moving
average. Bollinger bands are built on this very principle. This figure is
composed of three trend lines: the middle, upper and lower
bands.
The middle band corresponds to a simple moving
average, often calculated on 20 days.
The level of the upper band, in every point,
corresponds to the sum of the level of the middle band and
twice the value of the standard deviation associated to the moving
average.
Reciprocally, the level of the lower band
corresponds to the level of the middle band diminished by twice the value of
the standard deviation associated to the moving average.
An envelop of the stock price is thus determined. This
makes it possible to then identify the variation margin in which the
stock should stay almost systematically. In the case of a stock following
a Gauss law, 95 % of the trades will thus occur between these bands.
These latter then constitute very strong support
(lower band) and resistance (upper band) levels. These levels
respectively represent interesting buying and selling levels,
particularly when no real trend appears on the market (and bands are thus
stable on both sides of the average), which enables to play with a
trading target (short term target).
In opposition, in a trend market, clues given by
bands are related to their spread. Indeed, a growing spread of bands
means a growing standard deviation, which is the sign of the beginning a
strong trend. Then, when bands narrow, variations on both sides of
the moving average get smaller, which suggests the end of a trend. It is
then possible to use bands as supports and resistances.