Bollinger bands introduced by John Bollinger are a technical analysis tool that measures a specific standard deviation surrounding a certain moving average. In most cases the default is 2-standard deviations around a 20 period moving average. This type of strategy is considered a mean reversion strategy in which a trader looks to determine how far prices will move before they snap back. When the price moves above a Bollinger band high it is likely to revert back to the mean. When prices move below the Bollinger band low, it is likely climb back to the mean.
When prices move above the Bollinger band high, a trader can sell a currency pair using a strategy that is mean reverting. When prices move below the Bollinger band low, an investor can purchase a currency pair using the same premise that prices will revert back to the mean.
The number of days or weeks used in the Bollinger band study can vary. There is no set number although the default created by John Bollinger is the 20-day moving average and 2-standard deviations. Traders can use weekly, monthly or intra-day points, as well as 10-days or 100-days, ETC… The standard deviations can also change. A short standard deviations will reflect a closer mean reverting process while a further standard deviation such as 3 standard deviations (instead of 2) which only be hit occasionally. Two standard deviations from the mean capture 95% of the distribution, while 3-standard deviations capture 99% of the distribution.
Bollinger bands can also be used to find periods when volatility is increasing or decreasing. When the Bollinger bands are narrowing, historical volatility is declining. If a security moves above the Bollinger band high and the bands are narrowing the market is less likely to continue to trend and will likely mean revert. On the other hand when the Bollinger bands are expanding, historical volatility is increasing, this means that a move higher or lower might continue.