Bollinger Bands are one of the most widely used and powerful technical indicators in the financial markets. Named after the creator, John Bollinger, these bands are made up of a series of bands placed at a certain distance around a certain Moving Average, generally a 20 period MA, that capture the dynamics of volatility in a certain security or market index.

To calculate Bollinger Bands, one takes a certain MA, the 20 period MA is common, and calculates two “bands” a certain distance from that MA, which is calculated by the volatility of the security. For example, the common distance to set the bands is two standard deviations.

This can be calculated in two ways: with historical volatility and a “squeeze” indicator.

The formula for Bollinger Bands can be broken down into three main parts. The first is the MA. As stated, this is generally a 20 period moving average of closing prices. This MA will then be set by the two bands which will be the distances from the MA. These two bands are the Upper and Lower Band, which are set two standard deviations from the MA.

• A “Squeeze” in Bollinger Bands is a situation where the upper and lower bands come together to form a tighter range. This situation happens when volatility decreases in the market or security being measured.
• A “Breakout” in Bollinger Bands is when one of the two bands of the bands breaks away from the other and is outside of the normal range. This generally means that the underlying security is exhibiting increased volatility.

The limitation of Bollinger Bands is that, like many technical indicators, they can generate false signals that do not accurately indicate the movement of the security. Bollinger Bands, therefore, must be used in combination with other indicators to confirm or negate the signals given.

In addition, Bollinger Bands do not necessarily accurately reflect changes in the underlying security or market, but are merely a measure of volatility, which is itself an abstract concept. Therefore, it is important to use them in conjunction with other technical analysis techniques.

In conclusion, Bollinger Bands are an extremely powerful technical indicator and are a staple of technical analysis. While the bands alone cannot give an accurate measure of the underlying security, they can be used in conjunction with other indicators and tools to generate trading signals and inform one’s decisions in the markets.

It is important to note, however, that false signals can be generated and one must be careful when making any trading decision.