bollinger bands

 

Techniques

BOLLINGER BANDS: USING VOLATILITY by Matthew Claassen

While most investors While investors and traders who use technical analysi lysis s have a host of momentumoscill oscilla ators and even a few vo volume lume indicators indicators they consult wit ith h in in their daily analysis, few use the tools available to measu sure re volatil volatility ity.. I beli lieve evevol vola atil til-ity is one of the most unde under-us r-use ed and least understood understood market a ttribu tes te seffective , ye t one of the reliable and eff ective tools tool s wm eost have at our disposal.

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Figure gure 1. S&P 500 with Historical Volatility and the Volatilit Fi Volatility y Index (VIX (VIX). Note from 1993 to 22 September 2003 the VI VIX X represented implied volatility of the S&P 100. As of of September 2003 the symbol for f or the S&P 100's volatility inde index was changed to VXO VXO.. The VIX VIX now represents implied  vo  v olatility fo forr the S&P 500. Prices shown include historical data calculated by the CBOE fo forr what the new VIX VIX would have been had it been in existence prior to to September 2003.

as sume tha the volatility re ading n inde x can bte su bstituted bstitu ted forrea an y oneof of a its components nts,, market technicia technicians ns have developed numerous tool tools s to measure the

torical volatility.(Historica volatility. (Historical volatility for for this Now let's let's look look at a differe different measure of  discussion discussio n is defined defined as the standard devi viaa-  vo  volatility. Figure 2 shows the S&P 500 with tion of the logarithmic price change of  a Bolli Bollinge nger Band overlay. For this illustra illustraclosing clo sing prices over a trailing trailing ten week peri- ti tion on the default settings settings used are those

here have been numerous studies studies of  of   volatility and the markets. Th  vo The ese studies reach two importa important conclusions.O conclusions. One is that volatility volatility is mean reverting. The result of mean reve version rsion is that vola volatility cycles cycles from periods of high volatility to periods of   vo  volatility of an individual st stock. Ex Exa amples od) od).. There have been numerous academic low volatility. A second characteristic of  include the Relative Volatility Volatility Inde Index by D. studies exploring exploring the relatio lationship nship between  vo  v olatility is that it is auto-c -co orrelated. Auto- Do Dors rsey ey, Chaiken's Volatility Volatility by Ma Marc implied and actual (historical) volatility. correlation refers to the fact that if volatili- Chaiken and Boll Bollinger inger Bands develo veloped ped by  Alt  Although some studies have repor ortted ty rises today it is probable that it it will rise  J  Jo ohn Bollinger. mixed results, for the most part we can contomorrow. It's these two characteristics of  of  clude that historical volatility volatility does not pro vo  v olatility that result in a degree of pre- Wit With h the tools tools we now have at our disposal disposal  v  viide much incremental info forrmation beyond dictabili dict ability ty that can benefi nefitt the analyst and there is no reason an analyst can't create create a that of implied volatility. We can see that in investor.  vo  v olatility index fo forr any stock or any index. Figure 1. Here I have plo plotted tted the S&P 500 In this article I am going to show a simple in the upperpanel, el,historical historical volatility volatility in the For most US equity investors investors their expomethod for f or how we can create a vol volatili atility ty center panel and the Vol Volatility atility Inde Index (VI (VIX) sureto measuring volatili volatility ty in the the markets is index for any individual stock using in the the low lowe er pa panel. As expe expect cte ed, the limited to the Volatility Index (VIX) for the Bol Bolli linge nger Bands and discuss how we can  V  Vo olatility In Ind dex and historical volatility corS&P 500 and (V (VIIXN) for for the Nasdaq 100. use vol volatil atility ity to improve improve our investment relate very well. The VIX VIX almost appears to These implied measures of volatility are ti timing ming and analysis. be asmoothed vers rsion ion of historical vola volatilderived from from the option option premiums for the ity with the peaks and troughs of each linunderly rlying ing index. Howeve verr, the VIX and ing up perfectly. We can conclude, therethe VIX VIXN are limited in that the implied Bollinger Ba nger Bandsasameasureof volatility  fore fo re, that the Volatility Index provides a  vo  v olatility th they measure is restricted to to th the reasonable representatio tion n of actual volatilivolatiliindices themselves and not individual To start, we should first first explo xplore re the rela- ty. issues. Becaus use e it could be perilous perilous to tio tionship nship between implied volatility volatility and his-

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width of Bolli Bolling nger Ba Bands compares very very well with the Vola Volatility tility Index. Index. Virtually every peak in the VIX VIX is matched with a peak of similar magnitude in the Bol Bollinger linger Band Ba nd Width. Every major trough or low period in the VI VIX is matched with a similar trough and similar low perio riod. d. What you are seeing is that the Bolli Bollinge nger Band Width can be used as a reasonable substitute substitute for for the the  Vo  V olatility In Ind dex. Th The e diff ffe erence is that th the Bolli Bol linge nger Band Width can be easil sily y applied to any sto tock ck or any index.

 Vo  V olatility  y as as an indi indicator  cator 

Figure Fi gure 2. S&P 500 with Bollinger Bollinger Band & Bollinge Bollinger Band Width

Figure Fi gure 3. S&P 500, Volatility Inde Index (VIX (VIX)) and Bolli Bollinge nger Band Width

So how can this benefit us? First, by monitoring to ring a stocks volatili volatility ty range we can better identiffy the best periods to purchase or sell identi a security. Second, vol volatility atility can be used as a confirming indicator in conjunction conjunction with price or volume oscillators. Third, volatility can be used as a stand alo lone ne entry signal for for stocks already identified identified as pot potential ential buy candidates. Since volatili volatility ty reverts to its its mean we know that extreme high volatility volatility should be folfollowe lo wed by lower volatility volatility and extreme low  vo  v olatility should be fo folllowed by higher  vo  v olatility. Th Thu us if if we identify a stock th that our indicators indicators suggest is is an attractive purchase but find find that that it is is already at an extremelevel of high volatility volatility wemay benefitt from efi from holding holding back our purchase until  vo  v olatility has reverted towards its mean.

found in most technical analysis softwa software where Bo Bollllin inger ger Bands are two standard deviationsof a20-pe period riod time horizon. horizon.The The upper band represents + two standard deviations, the lower band - two standard deviations atio ns and the center line line a 20-perio 20-period d simple moving moving average. When we look look careful-

 An ex example of how th this mi might work is cha art of TA TAS SR Intl (TAS (TASR), bands decreases. The easy way to see this is is found in the ch Fig ur e 4. TAS TA S R Int. w a s one of the most by displaying the Bol Bolli linge nger Band Width in popular ar stocks for for 2003 and the first few few the lower panel. The band width increa increases popul months ths of 2004. It advanced from literally durin du ring g pe periods riods of high volatility and mon pennies es per share to nearly $60 in one one year. decreases during periods of low volatility volatility. penni  Altthough in hi hindsight we we ca can sa say al all an But how good a measure of volatility are  Al investor ha d to do wa s buy a nd hold, it wasBolli Bol linge nger Bands?

ly at the the Bolli Bollinger nger Bands we can see that as the S&P 500 becomes more volati volatile le the width of the bands incre increases. As the S&P 500 becomes less volatile the width of the

We compare the Boll Bollinger inger Band Width measu sure re of volatility to the Volatility Volatility Inde Index in Figur Figure 3.Here 3. Here we can clearly seethat the

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n't so easy in reall-time time. Momentum oscillators are of lit little tle value during such perio iods ds because of their tendency to remain overbought. How Howev ever er, us using ing what we know

 

Techniques

“One shouldn't use a price-based indicator to confirm another price-based indicator. It's like asking your mother if she's proud of you.” about volatili volatility ty we could time our entry and exits with confi confiden dence. The first thing I want you to notice notice about the Bolli Bollinger nger Band Width measure of   vo  v olatility in Figure 4 is its cyclical nature. We can see volatili volatility ty moving moving to an extremeand reve vertin rting g to its mean. Secon cond, d, notic notice e I placed amovi moving ng average (in this this case, a five period exponential MA) on the Bollinger Bollinger Band Width. Using this moving moving average we can more easil sily y identify identify when vol volatil atility ity is expanding or contracting contracting (remember the autoto-corre correlatingnature of volatility).

In August of 2003 at point "A "A"" TAS TASER  TA TASER SER went sidew sideways for for six six weeks while broke to a new high on record volume volumeafter  vo  volatility contracted. Th The e better entry point a brief retracement. An investor us using ing a came with another another sharp breakout in midbreakout system woul ould d expect prices prices to Septembe berr (point B). This time volatility volatility conti co ntinue nue and may have used that signal signal as a was the llowes owest it it had been in six six months. months. "safe" entry entry point. The investor investor using the the Bollinger Bol linger Band Width to to measure vol volatility atility From the the September breakout to the peak  woul ould d see that volatili volatility ty had expanded to a in volatility on late October (point C) range that was equal to to the the last volatil volatility ity TA TAS SER gained more than 100%. Many extreme in early May. Since volatility volatility is investo investors rs were tempted to chase the stock  stock  mean reverting reverting we woul ould d know know that the along the way. Momentum oscillators like like probability of of a substantial expansion from the stochastic and Wilders RSI stayed above this point point is is low and woul ould d have waited for for 50, which is bullish, but provides little cona be better tter opportunity. From tha thatt point

fi fiden dence of .their nature toity stay over bough t be forcau for soselong Using volatility volatil we cansee that in late October October volatility volatility began to contract cont ract from from a record high extreme. Rather than chase the stock, we coul could d wait forr our volatility signal for fo for a sa safe entry entry. In the next ten weeks, using the movi oving ng average as a signal line, line,we wereceived two buy buy signals. The first came in late November on a price breakout to to a new high and relatively low volatility volatility. The second occurred at point D in early Janu January 2004. 4.Here Here again we have a price breakout to new highs from from a poi point nt of low volatility volatility only this timevolatility was the lowe lowest it it had been in ten ten months.  A similar buy signal occurs at point E where the stock begins to advance off a base with  vo  v olatility ex expanding fr from a low le level. As TAS TA SER approached point F in in early April April

Figure Fi gure 4. TASR Intl. (TASR (TASR))

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Figure Fi gure 5. Al  Alc coa (AA AA))

2004, we know that volatility volatility has expanded supports the conclusion that the up-tren up-trend evaluate Alcoa (AA (AA). ). At point A the stoto its its highest point point in six months and is from April 2003 to April April 2004is being cor- chasti tic c oscill oscillator ator gave a buy signal as it overbought. At point F, volatility is be beg gin- rected. hooked hoo ked up from from an oversol oversold d level. ning to contract contract from from this high level and shortly after TAS TASER tes tested its trendd-line. line.  A supporting role However, vol volatili atility ty hadnot yet reachednear It's after poi oint nt F that I believevolatil volatility ity proa previous low low and hadn't turned upward to  viides us with the most intriguing signal.  v One shouldn' shouldn'tt use a priceprice-base based indicator indicator indicate an expansion. The resulting move From its April 2004 peak, vol volatility atility at fi first rst to confirm confirm another price-based indicator. in Alco Alcoa a from that stochastic buy signal was contracts along with TAS TASER's price. Then It's like a askin sking g your your mother if she's proud disappointing. A better signal occurred at in mid-Apri mid-Aprill volatili volatility ty expands as the price of you ou.. Of cou ourrse we know what th the poi point nt B and point C where the stochastic of TASER continues to declin cline e. Up to this this answer will be. Instead I prefer to combine gave the same buy signal but this this time time point poi nt volatili volatility ty expanded when the stock  indicators based on price, volume an and d  vo  volatility was beginning to ex expand fr from a was advancing and contracted contracted during  v  vo olatility. Th Thiis way our indicators are each lo lowe wer level. counter trend moves. This is the fi first rst time based on dif ifferen ferent aspects of the market. since TAS TASER began its up-trend up-trend that When they all conf confirm irm I know the probabil-  V  Vo olatility was also useful at point D in early  vo  v olatility expanded while the stock's pr price it ity y is they they are sending me the correct correct mes- 2004. Here too the stochastic oscillator oscillator was declined. This brings us to another impor- sage. oversold and turningup. Vol Volatility atility was inditant ta nt characteris ristic tic of vola volatility; tility; vola volatility tility is cating that Alcoa Alcoa was not as oversold oversold as the not directional.I directional. In otherwords volatility volatility can I had suggested earli rlier er that volatil volatilit ity y can be price based oscill oscillator ator suggested and that it it expand or contract while the underlying usedasaconf confirming irming indicator indicator in support of  of  may not be wort orthwhile hwhile acting upon the stostosecurity is is mov oving ing in either directio direction. n. momentum oscillators. The Bollinger Band chastic signal. The resulting move to the Width is an ideal tool tool to combine combinewith price double top high high in March (point E) E) proved To the analys lyst, t, the expans nsion ion of volatility and volume indicators indicators to help analyse an to be minimal. while thestock price of TA TAS SER declined in investment. late April April 2004 should tell us that the stock   At po point E, E, both th the stochastic os oscillator has undergone an important important change of  Figure 5 offers an example of com combining bining and vol volatility atility worked in concert to provide character. That this change is occurring the Bolli Bollinger nger Band Width measure of  a strong signal that that prices were not going shortly short ly after an important trend-li trend-line ne break   vo  volatility with th the Stochastic Oscillator to to higher in the immediate futur future e. The sto20

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Techniques

Figure Fi gure 6. TA TAS SER (TA (TASR) SR) & the Bollinger Bollinger Squeeze

chastic oscillator oscillator gave a sell signal from from it its s the bands narrow narrow to a where they appear to fo forr short to interm intermediate term trades, we overbought range whil hile e volatili volatility ty turned squeeze together. The expectatio tion n is that don' don'tt have to actively search for for them to down from from a high point point that had held for for this period of extreme low volatility should take advantage of the opportuniti opportunities es they four months. be follow followed by a period of extreme high pr provide ovide. If we can simply recognize this When Alcoa Alcoa appeared to be testing its its  vo  volatility. More oft fte en than not, the ensuing special case of extreme low volatility volatility in the trend-li trendline ne resistance at point F the the stochas- expansion of volatility that is born from a course of our analysis we will know when tic oscillator oscillator indica indicated that Alcoa Alcoa was over- Bol Bolli linge nger Squeeze includes an explo explosive sive the ensuing move move warrants a higher combought. At the sametime volatility volatility had con- move in the underlying stock. mitment of funds and greater confiden confidence in tracted telling telling us that an expansion in our action.  vo  v olatility wa was lik likely an and that the en ensuing The Bollinge Bollinger Band Width allo llows ws us to use price trend coul could d be strong. The price went on one e of th the e sim simpl ple er defin finiti ition ons s of The down to point point G where again both indicaindica- Squeeze asdefi defined ned in John Boll Bollinger's inger's book   An  Analysing in 3D tors worked in concert, this time to mark  "Bo "Bollinge llinger on Bollinge Bollinger Bands Bands". A squeeze the low in price. occurs when the Bollinger Bollinger Band Width is is Using volatility volatility adds a dimension to our the lowe lowest value (narrowest) it has been in technical analysis not not found found in price and Rather than simply mimic the price oscillaoscilla- six months.  vo  v olume based oscillators. It can add value as tor, the Bollinge Bollinger Band Width adds value by a support upporting ing tool tool or or as astandstand-alone alone indicashowing us a characteristic of the market With the TA TASER example there there were two to torr to help us understand and predict the that the price oscillator oscillator is simply not prooccasions occasio ns wherevol volatil atility ity had declined such price behavio viorr of any security. grammed to do. do. that the Bolli Bollinge nger Band Width was the lowest it had been in six or months. On both Matthew Claassen, CMT, is a charter  occasions occasio ns the result lting ing move in TASER  TASER  member of the American Association of  The Bolli Bollinger nger Squeeze was stron strong g. In Figure 6, I sh show ow TASER  Professional Technical Analysts again, this time time with the Bollinge Bollinger Bands. (AAPTA) (AA PTA) and is a current Director of  The Squeeze is one way of us using ing the the Market Technici Technicians ans Associati Association on Bollinge Bolli nger Band Width as astand alo lone ne tool. tool. It got its name from the look of the Bolling Bolli nger Ba Bands nds du during ring a period of protracted low vola volatility. As volatility contracts

The Bolli Bollinger nger Band Squeeze set-up set-up takes Educational Foundation (MTAEF). (MTAEF). advantage of the fact that volatility volatility is is mean He is is also the author and publisher of  reverting. Altho lthoug ugh there are numerous The Technical Vi View ew market report traders that search for for this this Squeeze set up  ww  www.thetechnicalview.net.

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