How Bollinger Bands Help Make Sense of Volatile Stocks

Bollinger bands are a type of limit measures that are plotted based upon the standard deviation levels above and below a selected moving average. 

The result of this exercise is to produce bands that widen during periods of high volatility, or contract when trading occurs in a less volatile fashion.   

Gauging Market Interest via Bollinger Bands 

Consequently, when these bands are large for a particular stock, it is a sign that there has been serious market interest in the underlying company. 

In this sense, Bollinger bands can be viewed as an indicator in regards to the supply and demand of the underlying security in question.   

When a stock is in a period of low volatility, which is usually characterized by a horizontal trading pattern, these bands contract towards the moving average. 

This would usually occur when the market for the stock is in a period of indecision.  One would suspect this type of activity between major news announcements when volatility typically drops significantly. 

Spotting Breakout Potentials  

As a measure of volatility for stocks, Bollinger bands can represent areas where many investors place orders to protect against an unfavorable breakout concerning their position. 

Typically, when the bands have been narrow for a significant period of time, a breakout from the band can represent a fairly strong indication that volatility will increase in the direction of the breakout. 

Such an occurrence, therefore, should be regarded as a possible trading opportunity. 

Trading near the upper or lower Bollinger band limits is also interpreted as a possibility that a trend reversal is about to occur. 

This does not always materialize, however, and one should always use other indicators in conjunction with Bollinger bands to confirm a suspected market reversal.

This prudent approach also holds true for when trading breaks out of the Bollinger limits.  Whatever the move anticipated by an individual investor, he or she is always wise to use confirmation indicators before undertaking a position. 

Measuring the Value of Oversold or Overbought Securities 

As a volatility measure, Bollinger band limits basically indicate whether an individual stock is overbought or oversold.  However, they do not in and of themselves indicate a buy or sell signal.   

Bollinger bands are actually indicators as to the volatility of a particular security.  As a result, for trading purposes, one would want to look at the activity of trading within the bands in conjunction with another tool, such as the Relative Strength Indicator, to properly undertake investment decisions. 

Historically, when a price movement has been identified originating at one of the Bollinger limits, it will more likely than not continue at least to the opposite limit band. 

Bollinger bands are in essence a graphic representation of the volatility that exists in the market for any particular stock. 

As such, they allow the investor the possibility to identify periods where opportunities for the undertaking of successful positions can arise.

When used in conjunction with other indicators, the knowledge and use of Bollinger bands can greatly improve any individuals trading performance.