They consist of three lines: a simple moving average (SMA) in the middle, with two outer bands set two standard deviations away from the SMA. The bands expand and contract based on market volatility; when prices are stable, the bands narrow, and during periods of high volatility, they widen. Traders use Bollinger Bands to identify potential buy or sell signals when the price touches the outer bands, suggesting overbought or oversold conditions.
Bollinger Bands Example
For example, if a stock’s price rises and reaches the upper Bollinger Band, a trader might interpret this as a sign that the stock is overbought and consider selling or shorting the stock. Conversely, if the price drops to the lower band, it may signal an oversold condition, prompting a potential buying opportunity.