Bollinger Bands
Definition
Bollinger Bands are three lines plotted around price: a middle moving average and two outer bands set at standard deviations above and below it — they show how stretched or compressed current price action is relative to recent history.
Example
“The bands had been tightening for three weeks and then price exploded through the upper band on the heaviest volume in months. That squeeze breakout was textbook.”
Detailed Explanation
The bands expand when volatility increases and contract when volatility falls. The contraction phase — called a Bollinger Band squeeze — often precedes a significant move. The tricky part is that the bands don't tell you which direction the move will go. They just signal that something is about to happen. Experienced traders wait for the directional break and confirmation from other factors — trend, volume, news — before committing.
The most common misuse of Bollinger Bands is treating a touch of the upper or lower band as an automatic sell or buy signal. In a strong trending market, price can "walk the bands" — hugging the upper band for extended periods during a strong uptrend. A stock touching the upper band in a strong uptrend is showing momentum, not exhaustion. Context is everything. The mean-reversion interpretation only makes sense in a range-bound environment.
For practical application: use the squeeze (band contraction) to identify setups where a big move is building. Use band position relative to the middle moving average to gauge trend health. And use band width expansion after a breakout as confirmation that a real move is underway versus a fakeout. The 20-period SMA in the middle is also a useful dynamic support/resistance level on its own.