Bollinger Bands is one of my favorite trading indicators, but not everyone knows what is standard deviation in Bollinger Bands and what it means when using it as a trading strategy.
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John Bollinger created the Bollinger Bands in the early 1980’s. John Bollinger was trading options at that time, and a lot of his analysis depended on analyzing market volatility. Measuring the standard deviation as a measurement of volatility meant that he could measure volatility dynamically, by expressing it as a standard deviation.
All of this still does not answer what is standard deviation in Bollinger Bands, but we will get to that in a moment. This is what Bollinger Bands look like on a trading chart:
In this particular chart, the settings for the Bollinger Bands are set to 20 periods with the standard deviation set to 2. Let’s discuss what is standard deviation as it pertains to Bollinger Bands. Imagine the Bollinger Bands to act almost like a road, and that the market prices, indicated by the candlesticks, are like cars on a road.
I’ve chosen racing cars in this case, since it’s easier to visualize. There are stages in a race, like at the start when the road or racecourse is straight, where the cars vie with each other to get to the best spot. Their movements are very limited, and although they move left and right across the road, because the road is straight, there really is not a lot of volatility. When the road opens up, we start seeing them hugging the corners as the race takes direction and becomes more volatile.
Their standard deviation starts increasing, since their movements begin to change from being confined to a narrow straight road, to a more open winding track. When we speak of standard deviation in a scientific sense, the general assumption is that within 1 standard deviation we will find about 68% of all cases, and within 2 standard deviations we will find 95% of all cases.
What does that mean? Let’s return to the race track example, most of the time, all of the cars will stay within the boundaries of the road. The boundaries of the road when it comes to Bollinger Bands, are the upper and lower bands of the 2nd standard deviation. When one of the cars go outside those boundaries, and go off the pavement, it is not considered normal. The car either spun out, and will return to the road, or it might be that something else changed, and now the cars will all start following the new route – like if there was an accident and they all needed to avoid it.
When watching cars race like that, we know that they’re hugging the corners of the track because they’re moving in a new direction, just like market price action “hugs” the upper or lower Bollinger Bands because they are going to move in that direction. The bands of Bollinger Bands are the standard deviation lines, the “road” of the market. The same happens with the markets, as prices start start moving away from the average, away from the line in the middle of the road, and start trending to the top or bottom of the Bollinger Bands, we know that the market direction is about to change.
When prices are close to, or even outside of the upper or lower Bollinger Bands, we know that they are touching the outer limits of the 2nd standard deviation, and that it is not a “normal” place for the market to be. Where the 2nd stand deviation usually includes 95% of all cases, with the market, it usually represents the boundary within which you will find roughly 80% of all market movement. Therefore we know that just like in a car race, once price moves outside of the 2nd standard deviation, which is represented by the upper or lower Bollinger Band, something is about to happen.
If the “road” or the outer bands of the Bollinger indicator is straight, and we get price movement outside of the band, we can almost be sure that it is “driver error” and that price will return to the “road” inside the Bollinger Bands. However, once we start seeing the road widen, and prices start hugging the corners, we know that the market has chosen a new direction and is likely trending.
I hope that this has helped to answer the question of what is standard deviation in Bollinger Bands, and that you will be able to “drive” the markets better going forward!