Trading with Bollinger Bands

January 29, 2016 09:00 AM

Popularized by John Bollinger, Bollinger Bands describe the technique of applying a relatively common statistical measure to the markets. In layman’s terms, they can be thought of as “volatility bands” charted above and below a moving average. They widen during periods of larger price changes and narrow during times of small price changes.

Bollinger Bands are similar to moving average envelopes, but the difference between Bollinger Bands and moving average envelopes is envelopes are plotted at a fixed percentage above and below a moving average. In the case of Bollinger Bands, the volatility measure is standard deviation, a term known well by anyone who has taken a rudimentary statistics course. Bollinger bands are drawn within and surrounding the price structure of a trading instrument. They provide relative boundaries of highs and lows.

Calculation

Bollinger Bands are displayed as three bands. The middle band is a normal moving average. Usually, a 20-period simple moving average is used. This is the trend indicator. The upper and lower bands are then a measure of volatility to the upside and downside of the trend. They are plotted two standard deviations from the middle band. 

Upper band = Middle band + 2 standard deviations

Middle band = 20-period simple moving average

Lower band = Middle band - 2 standard deviations

“Tracking volatility” (below) charts Bollinger Bands on the cash S&P 500 (SPX). The bands were at their widest when prices were volatile during August 2015. They narrowed when prices entered a consolidation period during March-June. One theory is that a narrowing of the bands increases the probability of a sharp breakout or breakdown in prices; the longer prices remain within the narrow bands, the more likely a price breakout will take place.

Bollinger Bands are used to both identify tops and bottoms and for trend-following.

Short-term extremes

When used to identify potential tops and bottoms in a stock, futures or exchange-traded fund, the following three behaviors should be on the trader’s radar:

  • a trending price move beyond the upper band,
  • a pullback toward the middle of the Bollinger Bands,
  • and another move higher (past the previous price high), but not closing above the upper end of the Bollinger Bands.

A Bollinger Band top signals losing momentum in an uptrend. It is important to remember that closing prices are more important when using Bollinger Bands  than intraday price moves. 

We can use some recent price activity in Microsoft as an example (see “Bottoms and tops,” below). We can see that Microsoft starts rallying from the lower end of its Bollinger Band at $44 on July 7, 2015 (marked by a yellow circle). It rallied until it reached $47 (shown on the blue circle) on July 21, 2015. Our first condition noted earlier is satisfied. 

After that, the stock saw a correction, dropping until it touched the middle band at $45 on July 28, 2015 (marked by a green circle). This satisfied our second condition.

Next, the stock again staged a rally until Aug. 5, forming a new high at $48, but it was unable to close above the upper Bollinger Band on Aug. 5, (marked by a red circle on the chart). It also formed a bearish candlestick pattern while satisfying the third condition: Another move higher (past the previous price high) but not closing above the upper end of the Bollinger Bands.

At this point, a trader employing this strategy would short with a stop-loss at $48 and a target of the lower end of the Bollinger Band. In this example, that was achieved on Aug. 24 (red line). 

The reverse rules can be applied for identifying short-term bottoms. 

Identifying trends

Bollinger Bands can reliably indicate forthcoming trend moves when prices move above or below them. 

A move above the upper band shows strength, while a sharp move to the lower band shows weakness. As per classical technical analysis, overbought conditions can extend in a strong uptrend and oversold conditions can extend in a downtrend. 

Similarly, prices can touch the upper and lower end of the Bollinger Band numerous times during a strong uptrend or downtrend. 

It is also common for prices to never reach the lower band during an uptrend and upper end during a downtrend. The 20-day simple moving average making up the middle line of the Bollinger Band sometimes acts as support and resistance in either an uptrend or downtrend.

Dips around the middle line sometimes provide buying opportunities during a strong uptrend, while rallies near the line sometimes provide selling opportunities during a downtrend.

In “Creeping lower” (below), we can see this behavior in Caterpillar. As shown in the chart, price touched the upper end of the Bollinger Band on June 23, 2015, at $88. This is marked by the blue circle. Price then started correcting, closing below the middle line at $86 on June 26. Price continued with its correction and touched the lower end of the Bollinger Band (marked by a yellow circle) on June 29 at $84.30. 

At this point, shorts could be taken with a stop loss price closing above the middle line. In this example, price continued with its correction, reaching a low of $80.71 on July 9. 

After touching the low, price started showing a pullback and rallied until the middle line of the Bollinger Band (shown by a green circle). However, it was unable to close above it, formed a bearish candlestick pattern and began another trending move lower. 

Versatile tool

Bollinger Bands can do many different things at the same time. One reason for this is they are a direct derivative of price and can be combined with a number of other indicators, without creating much noise.

Bollinger Bands reflect direction with the 20-period moving average and volatility with the upper/lower bands. As such, they can be used to determine if prices are relatively high or low.

Statistics suggests that the bands should contain 88% to 89% of the price action, which makes a move outside them significant. Technically, prices are relatively high when above the upper band and relatively low when below the lower band. However, relatively high should not be regarded as bearish or as a sell signal. Likewise, relatively low should not be considered bullish or as a buy signal. Prices are usually high or low for a reason.

As with other indicators, Bollinger Bands are best used with other methods of analysis to determine what the price moves are reflecting. Traders can combine Bollinger Bands with other technical indicators or with fundamental analysis to confirm signals and discover further insight into the market’s intentions.

About the Author

Bramesh Bhandari is a proficient stock trader at Indian stock market.He share his insight in Forex,Commodity and World Indices through his site http://www.brameshtechanalysis.com. He also provides online tutoring on technical analysis to traders.He can be reached at bhandaribrahmesh@gmail.com.