I was dusting out a cupboard the other day when I came across an old favourite of mine; a technical indicator called the Bollinger Band. I used to use this religiously, but somewhere along the line I mislaid it. Now, after applying it to a few charts I’ve put it back on my play list.

What Are Bollinger Bands
They were developed by a guy called John Bollinger, who has nothing to do with fine wines or champagne.

We’ve previously talked about moving averages. Well, think of Bollinger Bands as a couple of guys in sharp suits and sun-glasses. They walk either side of the moving average, keeping a watchful eye on the price and shouting when they think it’s overstepped the mark.

Looking Under The Bonnet
Bollinger Bands track a moving average, but instead of using fixed percentages (like moving average envelopes) they use a standard deviation based on the price movement of the moving average. This means that instead of the ‘minder’ lines running at a fixed distance, they expand and contract, depending on how volatile the price movement has been.

There are only two numbers we can tinker with; the time span and the standard deviation.

Time Span
Just like with moving averages, the longer the time span the smoother and less sensitive the fluctuations of the bands; a short time span will produce a sharp, jerky line. And just like moving averages, you can play around and find what time span suits you best. Mr Bollinger recommends using a 20-period moving average.

Standard Deviation
I won’t get too Stephen Hawking about standard deviations; in simple terms a standard deviation is a statistical concept that deals with price dispersal around an average price. Phew!

The option is there to experiment with the number of standard deviations, or the quick way is to read the conclusions of clever people who have already done the leg work. A standard deviation of 1 would produce lines so close to the moving average that the signals would be frequent and useless. Equally, a standard deviation of 3 leaves room for a bus lane and is just as useless.

So somewhere in the middle leaves 2 standard deviations. This number is said to cover about 95% of the price move, or in simple terms, the price should stay inside the Bollinger band for 95% of the time. Mr B recommends using 2 standard deviations.

Where Do I Find These Bollinger Bands?
Click on the ‘Settings’ tab in the bottom left-hand corner of the chart. Near the top of the drop down you’ll see the box for Bollinger Bands. The settings are pre-set to a 20-period moving average and 2 standard deviations but, hey! If you fancy experimenting have a shot at some different numbers.

How Do We Use Them?
1) As A Target
Think of it in George Bush terms; you’re either with us or against us. If the price is below the 20-day moving average, then treat the lower band as a price target (or the lower band and the moving average as a trading range).

If the price crosses above the 20-day moving average, then treat the upper band as a target (and the upper band and the moving average as a trading range). Simple, innit?

2) As A Limit
In simplistic terms, when the price hits the top band it’s overbought; when it hits the bottom band it’s oversold. And of course, like all indicators, it’s rarely quite that clean. Because, in theory, the bands will contain the price for most of the time, if the price wildly overshoots the band it’s worth questioning at the very least. If there isn’t a compelling reason for the move (think Northern Rock/ RBS) then there’s a fair chance the price move will reverse back inside the line.

However, some techie guys will say that if the price does move outside the bands, it’s the sign of a strong trend, even if the price re-traces back inside initially.

The HSBC chart shows good examples of several of these points.

• In mid-September the price bounces off the bottom of the band, breaking the 20-day moving average before bouncing off the top band. Notice that for most of the period the price trades between the lower band and the moving average, a sort of squelchy trading range.
• There are several points when the price overshot the band, but rallied within a day or two to a higher level.
• Ah but! Note the times (marked with an X) when the price fell on specific news. Here the lower band adjusted to the new, lower level with no subsequent price rise.

3) A Peak Into The Future
OK, this is about as reliable as Mystic Meg, but clocking the band widths can occasionally send an early warning signal. I said earlier that the bands contract and expand, depending on the level of volatility in the market. When these reach extreme levels there’s an increased likelihood of a change in the market.

Check out the EURUSD chart above. See how the band width narrowed during November-December as the price consolidated in a 500-pip range. This was a warning of a breakout in the near future, and sure enough a break above November’s high sent the Euro skywards during December. Then after a period of excessive price movement in both directions the bands contracted as traders took a breather, waiting for a new signal.

Of course Bollinger bands aren’t foolproof; no system or indicator is. But combined with an oscillator, like an RSI or MACD, it’s another useful measure of whether a price is overcooked or where you could expect to set your next price target.