Bollinger Bands

 

TRADING TRADIN G Bas Basics ics

Indicator Insight:

BY ACTIVE TRADER STAFF

Bollinger Bands

FIGURE 1 BOLLINGER BANDS VS. MOVING MOVING AVERAGE AVERAGE ENVELOPE ENVELOPE While moving average envelopes (top chart) move higher or lower together, Bollinger Bands can move in opposite directions (lower chart). S&P index-tracking stock (SPY), daily

ollinger Bands are a type of  trading “envelope” consisting of lines plotted above and  below a moving average

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Moving average envelope moves in tandem

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designed to capture a market’s typical price fluctuations. The indicator is similar in concept to the moving average envelope (see Indicator Insight, Active Trader September 2002, p. 88), with an important difference: While moving average envelopes plot lines a fixed percentage above and below the average (typically three percent above and below a 21-day simple moving average), Bollinger Bands use a statistical measurement of  the closing prices called stan standard dard dev devia ia tion (see the next section) to determine how far above and below the moving average the lines are placed.

As aofresult, while the upper and lower lines a moving average envelope always move in tandem (Figure 1, top 10 18 chart), Bollinger Bands expand (i.e., the F e b r u a r y top band can rise while the bottom band falls) during periods of increasing marSource: MetaStock ket volatility and contract during periods of decreasing market volatility (Figure 1,  bottom chart). Bollinger Bands were created by John Bollinger, CFA, CMT, the president and founder of Bollinger Capital Management (see Active Trader , , April 2003, p. 60).

Calculation The classic approach to this indicator is to place the upper and lower Bollinger Bands two standard deviations above and  below a 20-period moving average. Upper band = 20-period simple moving average + 2 standard deviations 74

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Bollinger Bands expand and contract with the market volatility

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Middle line = 20-period simple moving average of closing prices Lower band = 20-period simple m moving oving average 2 standard deviations

Standard deviation is a statistical calculation that measures how far values deviate from an average value — in this case, how far prices stray from a 20-day moving average. The proper use of standard deviation calls for a sample of at least 30 observations, in which case, statistically, 95 percent of values will fall within two standard deviations of the average value. Because Bollinger Bands typically use just 20 days of closing prices, the bands will generally encompass 88 to 89 percent of  www.activetradermag.com • July 2003 • ACTIVE TRADER 

 

FIGURE 2

CONTRACTING BOLLINGER BANDS

When Bollinger Bands contract, as was the case beginning in mid-February, it can be a sign a higher-volatility trend move is about to begin. Nasdaq 100 index-tracking stock (QQQ), daily

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Bollinger Bands narrow

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the price action. (To learn more about standard deviation, see the Web Extra for this article artic le at www.activetradermag.com between June 10 and June 30, 2003.)

A nice trend run follows the narrow Bollinger Bands

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Interpretation and use Bollinger Bands provide two important pieces of information: first, whether volatility is by high or low, which can be determined measuring the difference or the width between the upper and lower band; and second, whether prices are high or low relative to past prices as well as within the context of the Bollinger Bands themselves. Watching for low-volatility conditions is a well-known trading technique,  because low volatility often precedes high-volatility trend runs. For example, Figure 2 shows the Nasdaq 100 indextracking stock (QQQ). During January and into mid-Februa mid-February, the Bollinger Bands were running at a nearly $3.50 differential. Then, as the market moved

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FIGURE 3 HEAD FAKES Contracting Bollinger Bands can sometimes lead to false breakouts. Here, new lows established after the bands contracted appear to signal the start of a downtrend in early March. However, it was just a “head fake” and price quickly reversed. Bed, Bath & Beyond (B (BBBY), BBY), daily daily

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into a lower-volatility range in February, the Bollinger trading Bands narrowed to a $2 difference. This volatility contraction was a sign to look for an emerging trend move. In this case, the market  broke through resistance at $25.50, and sprinted back to the January highs. Tags of the upper and lower Bollinger Bands can indicate temporary over bought and oversold conditions, but Bollinger stresses these events are not automatic reversal trade signals. In a strong uptrend, for example, price can repeatedly tag the upper Bollinger Band, similar to the way an oscillator will stay above its overbought threshold in the same circumstances. As a result, other information must be consulted to prov provide context for the Bollinger Band signals.

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Bollinger Bands are wide

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Support point

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Head fake Money Flow Index

Bullish readings greater than 50

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Indicator Insight continued from p. 75 A ba basi sicc techni technique que is to combine combine Bollinger Bands with another indicator. Bollinger, for example, considers volume analysis to be a valuable aid. Figure 3 (p. 75) is Bed Bath and Beyond (BBBY) with

lied sharply, driving the MFI into bullish market traded temporarily above the territory (readings above 50). The stock  falling 20-day moving average (the midadvanced an additional $6. The succes- dle band) and then fell back to the lower sive tags of the upper Bollinger Band fol-  band. Then, when the trend reversed, lowing the head fake were a sign of  there were buying opportunities where

Bollinger Bands and the Money Index (MFI), which is similar to the Flow relative strength index oscillator (RSI, see

strength — although overbought condition they indicatedthe created a temporary pullback to the moving average,

the price temporarily fell below the rising 20-day moving average.

Key points FIGURE 4 THE IMPORTANCE IMPORTANCE OF THE MOVING AVERAGE Strong trends are often characterized by price moving between the moving average and upper/lower band. The moving average functions as a basis support or resistance level, depending on the direction of the trend. S&P index-tracking stock (SPY), daily

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Downtrend, moving average acts as resistance

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Using confirming technicalelement tools or chart patterns is an important of  using this indicator. Bollinger Bands are not a tool to be used in isolation. Pick  indicators that compliment the Bollinger Bands, but do not replicate the same information. For example, using RSI and stochastics (another oscillator) along with Bollinger Bands simply gives you the same information from the two oscillators. Combine volume, an oscillator and the Bollinger Bands for a morerounded market perspective.

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Bottom line

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Uptrend, moving average acts as support

Although software programs allow you to adjust parameters, Bollinger suggests using the default indicator values — a 20-period moving average with bands set two standard deviations above and  below the average — at all times (see “Relatively speaking: John Bollinger,” Bollinger, ” Active Trader , p. 60). He advises traders who wish to adjust the indicator to shorter or longer time frames simply to use shorter or longer bars (e.g., 60minute bars or weekly bars, etc.).

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By providing a framework designed to

Indicator Insight, Active Trader , August 2001, p. 88), with an additional volume component. Figure 3 shows the MFI diverging as the price fell to new lows in March. This chart contains an example of a phenomenon Bollinger refers to as the “head fake” — a false breakout following a narrownarro w-

which then acted as support (a common occurrence during a trend). This highlights another valuable use of Bollinger Bands. The moving average provides a key point to watch during trends. While in a strong uptrend, price tends to trade between the upper band and the 20-day moving average.

contain nearly 90 percent of price fluctuations, Bollinger Bands are a tool for identifying whether price is relatively low or high at a given time. They can be used for setting price targets, identifying swing points and exhaustion moves, and pinpointing trend shifts. Probably their strongest value, though, is the ability to identify periods when volatility is dropping (reflected by narrowing bands) or exceptionally low, as this can set the stage for a good trend. Like most technical indicators, Bollinger Bands are not stand-alone tools, and “tags” of the bands should not be interpreted as reversal signals without taking

ing of the Bollinger Bands. During late Fe bru  bruaary, the Bollinger Bands narrow narro wed and the market fell to a new low. However, price quickly reversed and ral-

Conversely, during a strong downtrend, price generally fluctuates between the moving average and the lower band. For example, in Figure 4 (above) the

other evidence into account. Confirming information, such as volume and price patterns, can be used to determine the meaning of a Bollinger Band signal.Ý

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ACTIVE TRADER • July 2003 • www.activetradermag.com

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