Bollinger Bands
Bollinger Bands were developed by John Bollinger as a technical trading tool in the early 1980s. They arose from the need for adaptive trading bands and the observation that volatility was not static as was widely believed, but dynamic. Bollinger developed the technique of using moving averages with two trading bands. This is not unlike using an envelope on either side of a moving average. However, unlike using a percentage computation from a normal moving average, Bollinger Bands add and subtract a standard deviation calculation.
To put this in perspective, let’s define the term “standard deviation.” This term refers to a mathematical formula that measures volatility, thus showing how the stock price can be spread around its true value. The technician is relatively certain that most of the price data needed will be found between the two brands. The bands can’t be used to make reliable statements regarding what percentage of equity’s prices will lie within a certain distance of a mean value, because an individual equity price does not obey known distribution functions (the stochastic process). Standard deviations of stock prices for finite time periods are not fixed parameters as required to apply classical statistical theory. Instead, they are variables in constant flux dependent upon price volatility. When the bands lie close together, low volatility is indicated. Likewise, when the bands lie farther apart, high volatility is achieved. However, when the bands have only a slight slope and lie approximately parallel for a long period of time the stock’s price will oscillate up and down between the bands as though in a channel.
Bollinger Bands are used to provide a definition of relative high and low. This is an indication of prices being “high” at one end and “low” at the other end. Using this definition can aid in recognizing rigorous patterns and is useful in the comparison of price action to indicator action when arriving at systematic trading decisions.
Bollinger Bands consist of a centerline and two price channels. One price channel is above the centerline, and the other is below the centerline. This centerline is an exponential moving average. The price channels are standard deviations of the stock being studied by the chartist. Therefore, the definition of a “price channel” in this regard refers to the encompassment of the trading activity around the trend of trading after a sharp rise or fall in the market. The bands will expand and contract as the price action of an issue becomes volatile (this is expansion) or becomes bound into a tight trading pattern (the definition of contraction).
The middle Bollinger Band equals a 20-period moving average. The upper Bollinger Bands consists of the middle Bollinger Band plus the total of two 20-period standard deviations. The lower Bollinger Band is equivalent to the middle Bollinger Band minus the total of two 20-period standard deviations.
Two important tools are derivative of the Bollinger Bands. BandWidth, which is a relative measure of the width of the bands, is the first tool. BandWidth is calculated by dividing the result of the upper Bollinger Brand minus the lower Bollinger Band by the middle Bollinger Band. This is most often used to quantify “The Squeeze, “ volatility based trading opportunity. The second tool derived from Bollinger Bands is %b. this is a measure of where the last price is in relation to the bands. This is calculated by dividing the result of the last minus the lower Bollinger Band by the upper Bollinger Band minus the lower Bollinger Band. %b is most often used to clarify trading patterns. It is also used as an input for trading systems.
Markets trade erratically on a daily basis even though they are still trading either when they are up in the trend or down in the trend. Moving averages are used with support and resistance lines to anticipate the stock’s price action. These upper resistance and lower support lines are first drawn and then extrapolated to form channels. The trader expects prices to be contained within these formulated channels. Sometimes, straight lines are drawn connecting either tops or bottoms of prices in order to identify the upper or lower price extremes (respectively). Parallel lines are then added to define the channel within which the prices should move. As long as prices stay in this channel, traders can be reasonably confident that prices are moving as expected.
When the stock price touches the upper Bollinger Band continually, the price is thought to be overbought. Conversely, when stock prices continually touch the lower band of the Bollinger Band, the prices are considered “oversold,” and thusly a buy signal would kick in.
Designate the upper and lower bands as price targets when using Bollinger Bands. If the price deflects off of the lower band and crosses above the middle line (the 20-day average), then the upper band comes to represent the upper price target. Prices usually fluctuate between the upper band and the 20-day moving average in a strong uptrend. When this happens, a crossing below the middle line warns of a reversal in trends to the downside (lower band).
Use of the Bollinger Band among traders varies wildly. Some traders buy when the price touches the lower Bollinger Band and sell when price touches the moving average in the center of the bands. Conversely, other traders buy when price breaks above the upper Bollinger Band or sell when price falls beneath the lower Bollinger Band.
Bollinger Bands can also be used in combination with price action and other indicators to generate signals and foreshadow significant moves. A “double bottom buy” signal is given when prices penetrate the lower band and remain above the lower band after a subsequent low forms. It doesn’t matter which low is higher or lower than the other one, as long as the second low stays above the lower band. On the other hand, a “double top sell” signal is given when the prices peak above the upper band and the next peak fails to break above the upper band.
Not only stock traders use the Bollinger Band. Options traders (especially implied volatility traders) often sell options when Bollinger Bands are at their most historic difference or buy when Bollinger Bands are at their closest historic point. They do this with the expectation that volatility will revert back toward the average historical volatility level for the stock.
In conclusion, Bollinger Bands are helpful when generating buy and sell signals. They are not, however, designed to determine the future direction of a security. The Bands were designed to add to other analysis techniques and indicators. All in all, Bollinger Bands serve two primary functions: the identification of low and high volatility periods, and the detection of periods when prices are at an extreme and possibly unsustainable level.
To view how I use Bollinger Bands within my trade plans, check out my technical analysis video trade plans on YouTube @ http://www.youtube.com/accendotraders
Subscribe