In order to further understand the construction of the indicator, one has to understand the concept of standard deviation.

Standard Deviation

Standard Deviation is a statistics concept. It originates from the notion of normal distribution. For people who have ever taken a statistics course, normal distribution is akin to a bell curve. To take this example further, when a professor distributes grades on a “curved scale”, he or she is employing normal distribution. Most students will fall somewhere in the middle range (or mean) and get a B. There will be a few students that do very poorly and get bad grades, and those acing the test will receive A’s. One standard deviation away from the mean, either plus or minus, will include 67.5 percent of the students’ scores. Two standard deviations away from the mean includes 95 percent of the scores. There are only 5% of students that have the absolute best and the absolute worst scores.

How can this relate to foreign currency trading? The Bollinger Bands indicator’s main function is to measure volatility. What the Bollinger Bands upper and lower limits try to do is to confine using two standard deviations, 95 percent of the (possible) closing prices. It does this by comparing the current closing price with the moving average of the closing price. The difference between them, and thus the volatility of the current price compared to the moving average, will increase or decrease the standard deviation. When volatility is high, or prices close far away from the moving average, the Bollinger Bands increase to accomodate more possible prices that can fall within 95% of the mean.

Standard Deviation Formula

is the mean closing price for N periods as depicted by a moving average line.

is the closing price at each day during N periods (depicted by the sigma signal’s i).

N is the period, the default is 20 (can be in days, hours, weeks, minutes).

The construction of the Bollinger Bands is fairly straight forward, once one understands what standard deviation is.

The middle band is a simple moving average: Where n is the period.

The upper band is: Middle band + D
Here D is the number of standard deviations, the default is 2.

The lower band is: Middle Band – D

Bollinger considered the best default for his indicator to be 20 periods, but as with all indicators, some tweaking may be in order to give one better signals in a certain market. The bands are then overlaid on top of the price action.