Bollinger Bands ®

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Introduction

Bollinger Bands were developed by John Bollinger primarily as a trend following indicator. Curiously most traders primarily use Bollinger bands to trade overbought and oversold levels when prices are trading relatively flat. If one truly understands the power of Bollinger bands, then one realizes that it’s a versatile tool that can be used in a variety of trading conditions and is not a one dimensional tool as many traders believe.

Bollinger Band Calculation

Upper Band = Middle band + 2 standard deviations.
Middle Band = 20-period simple moving average.
Lower Band = Middle band - 2 standard deviations.

Standard Deviation formula

Where

 = the standard deviation
 = each value in the population
 = the mean of the values
 = the number of values

The calculations for Bollinger bands are very straight forward and simple. The bands are calculated by taking 2 standard deviations of the middle band. Bollinger suggested using a 20-period simple moving average to calculate the middle band. The middle band should be to be representative of the intermediate trend.

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Interpretation

The purpose of Bollinger Bands is to provide a relative definition of high and low price; prices near the upper band are high, prices near the lower band are low. The base of the bands is a moving average that is descriptive of the intermediate trend. The width of the band is determined by a measure of volatility. Bollinger used the standard deviation formula as his description for volatility. Prices touching the top of the Bollinger band are viewed as over extended above the intermediate trend. Prices touching the bottom of the Bollinger band are viewed as over extended below the intermediate trend. Bollinger in his book “Bollinger on Bollinger bands” viewed that the biggest myth regarding Bollinger bands was that touches on the outer bands where signals to take contra trend positions.

Walking Up The Bands

In his book Bollinger on “Bollinger Bands” repeatedly made reference to the fact that many traders typical make the mistake of selling when prices touch the upper band and buying when prices touch the lower band. In fact when prices hugged on one side of the band this was actually a continuation signal and not signal for a trend reversal. Bollinger referred to this as “walking the bands”. In the chart below we see after prices broke out in early December, the Agilent stock continued to ride the top of the upper Bollinger band for the next 2 months.

Bollinger discussed three primary methods for trading Bollinger bands in his book. They were the following:

  • Method 1, Volatility Break out
  • Method 2, Trend Following
  • Method 3, Reversals

Method One: Volatility Break Out

Bollinger surmised that while prices were neither cyclical nor forecast able, volatility was both. Periods of low volatility would be followed by periods of high volatility. Conversely, periods of high volatility would be followed by periods of low volatility. So according to Bollinger, traders looking to capitalize on identifying the beginning of a new trend should watch for periods of low volatility where the Bollinger Bands would narrow or “squeeze”. Subsequently as the bands would expand with the emergence of increased volatility and astute traders would trade in the direction of the break out.

To trade the “Squeeze” Bollinger created the Bandwidth indicator to monitor changes in volatility. The Bandwidth indicator measures volatility as a function of the middle Bollinger band. The longer prices stayed compressed or within a period of extremely low volatility, the more likely an explosive the break-out would occur. One caveat that Bollinger noted was that volatility break-outs from the squeeze had a tendency for false break-outs which he called “head-fakes”.

To sum up Bollinger’s first method, the first step is to use the Bandwidth indicator to search for stocks that are trading with relatively low volatility. The second step is watch for the squeeze and lastly to take position in direction of the break out.

Formula for the Bandwidth indicator

Bandwidth = (Upper Bollinger Band-Lower Bollinger Band) / (Middle Bollinger Band)

In the AMGN chart we see price break out to the upside in mid October. The Bandwidth indicator moves higher from relatively low levels as prices on the daily chart hug the upper Bollinger Band. Unfortunately for any traders adding bullish positions they found themselves caught in a head fake. AMGN traded from 58 down to 52 in the course of 5 weeks. Bollinger suggested that there was no method to keep getting blown of the water by head fakes. Only sound money management would do that.

According to Bollinger, the bands, are better suited for determining the beginnings of trends and should not be used for range trading between them. When the outer edge of a band is broken, look for the next move as a start of a new trend. Prices will tend to remain close to the band in the direction of the trend and give many false exit signals.

In the above chart of Priceline note how the Bollinger compress right before prices break out in the direction of the trend. As prices break out both outer bands will point outward.

Method Two: Trend Following

Method 2 is a simple variation to Method 1. The premise is to buy on strength that is signalled by another signal in addition to the Bollinger Bands. Conversely trader should also sell weakness that is signalled by another signal. The main difference from Method 1 is that there is no prerequisite of squeeze prior to a break out.

In the chart above the initial buy signal is given when MACD Histogram moves from negative to positive in December. The MACD line highlights the upward trending which is confirmed as prices “walk up” the upper Bollinger band. One trading strategy would be to buy any pull backs to middle Bollinger Bands line.

By using additional indicators we can see in mid January, The MACD triggered a bearish cross over sell signal. The important thing to remember is that this signal does not suggest that you should fade the current trend, but should perhaps take profits or prevent you from adding additional longs at a potential top. Only once price action has confirmed that prices have reversed should you look to fade the prior trend.

Method Three: Reversals

The third method can be simply described as selling the prices tag the upper Bollinger Bands when and additional indicators are signalling trend reversals. Conversely buying when prices tag the lower Bollinger Band and additional indicators signal trend reversals.

In the chart below we see Target Corporation had been in a nice up trend from November 2010 where prices “walked up” the upper Bollinger stalling in December. Right at end of 2010 we see prices begin to tag the upper Bollinger band while at the same time the MACD line is signalling a that momentum is weakening at that a reversal in the trend is eminent.

Patterns

By using chart patterns with Bollinger bands, traders can increase their odds in identifying successful trading opportunities. In his book Bollinger discussed a variety of patterns that could be used with Bollinger bands. He primarily discussed using M- Tops and W- bottoms in his pattern analysis.

M-Top

In the Amgen chart above we see how in the daily chart a double top is clearly identified with the M patter in late December- January. The MACD line is diverging with price action signalling a the Method 3 Reversal confirming the bearish M-Top price pattern.

W-bottom

In the daily chart of the Agilent stock above we see how a W-bottom signalled the beginning of a 2 and a half month rally. Notice how the W-bottom is confirmed with MACD bullish cross over and by price walking up the upper Bollinger band.

Conclusion

Bollinger created three methods for using Bollinger bands that let traders adapt to market conditions as they evolve. What makes Bollinger Bands interesting is how the wide spread belief in the retail trading community that Bollinger Bands are great tools for range bound markets, contrary to the man who created them. In fact two of the original methods are trend following methods.

Like most technical tools, traders need to remember that indicators and technical overlays should be used to confirm what price is telling them.