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Using Bollinger Bands
A useful indicator that incorporates volatility

Bollinger Bands were created by John Bollinger, and are curves that are drawn in and around a price chart.  They are designed to provide relative definitions of high and low, and are one of the most widely used technical indicators.  The anchor (middle line) for the bands is a moving average, while the band's width is determined by volatility.

Marc Chaikin, who also created the  Chaikin Money Flow indicator was one of the first to try and find a way to create a range around prices.  He suggested that bands be constructed to contain a fixed percentage of the data over the past year, still a very useful approach.  He used a 21-day average and suggested that the bands ought to contain 85% of all the price data.

It was John Bollinger that standardized the format by adding volatility as a key variable, using standard deviation as the way to set band width.  So Bollinger Bands are similar to moving average envelopes.  The difference between Bollinger Bands and envelopes is that envelopes are plotted at a fixed percentage above and below a moving average.  Bollinger Bands are plotted at standard deviation levels above and below a moving average.

Since standard deviation is a measure of volatility, the bands are self-adjusting.  They widen during volatile markets and contract during calmer times.  That has the advantage of making the bands sensitive to extreme deviations, so that Bollinger Bands very quickly react to large moves in the market.  The figure below shows Bollinger Bands plotted on the QQQ with two standard deviations above and below a 20-day simple moving average.

Bollinger Bands do not give absolute buy and sell signals based on the price touching the bands, although you may notice many reversals do occur near the bands.  Certainly the moving average itself provides support and resistance in many cases, as I mentioned in my article on  Simple Moving Averages.  What they do is answer the question of whether prices are high or low on a relative basis.

With that information, an investor can use the indicators to confirm price action when making buy and sell decisions.  For the equity markets and individual stocks, the 20-day moving average is popular for timing the intermediate-term trend.  For those watching the short-term trend, a 10-day period is often used, while the 50-day moving average is popular among long-term trend followers.

If the period for the moving average is lengthened, the number of standard deviations being used should also be increased.  For example, starting at 2 for a 20 day period, you might move to 2.5 for a 50 day moving average.  If the average is shortened the number of standard deviations should be reduced, say to 1.5 for a 10 day time period.

So how do you interpret Bollinger Bands?   Contracting bands warn that the market is about to trend: the bands narrow, followed by a sharp price movement.  In the QQQ chart above, you can clearly see this narrowing occur before almost every major push higher.  But be careful, because the first breakout is often a false one, preceding a strong trend in the opposite direction.  The narrowing at the beginning of August on the above chart is a good example of this.

A move outside a band indicates is not a reversal signal (unless the price quickly reverses, of course) but is a signal that the trend is strong and likely to continue.   Closes outside the Bollinger Bands are continuation signals, and are often used as the basis for volatility breakout systems.  A move that starts at one band will carry through to the other, even as the bands adjust.  Bottoms and tops made outside the bands, which are followed by bottoms and tops made inside the bands, signals a reversal in the trend. 

As with other indicators, Bollinger Bands work best in conjunction with other indicators.   A trend that hugs one band signals that the trend is strong and likely to continue, and in that case you should wait for divergence on a Momentum Indicator to signal the end of a trend.  In technical analysis you want to avoid multicolinearity among indicators.    Multicolinearity is just when you are using different indicators that are all calculated using the same data. 

Volatility and trend are already used to construct Bollinger Bands, so something like the relative strength index, which is based on price alone, is a good choice.   Closing prices and volume combine to produce on-balance volume, another good choice.  Or price range and volume combine to produce money flow. 

Bollinger bands are considered some of the most useful bands in technical analysis because the bands vary in distance from the moving average of the stock price.  Because standard deviation is a measure of volatility, Bollinger Bands adjust themselves to the market conditions, and makes the trading envelope more sensitive to price fluctuations.  That makes Bollinger Bands an indicator every serious trader should be familiar with.

Previous Newsletters

• August 2005 - The MACD – An Introduction
• July 2005 - How can you spot changes in trends ahead of the crowd?
• June 2005 - An application of the Langford forecasting method
• May 2005 - In-The-Money, At-The-Money or Out-Of-The-Money Calls
• April 2005 - Synthetic Option Strategies
• March 2005 - Why Investors Buy or Sell Call Options
• January 2005 - Mastering Short Selling
• December 2004 - Covered Call Writing
• November 2004 - Gain insights on Exchange Traded Funds.
• October 2004 - Features of the Recognia Inc.
• September2004 - What is Technical Analysis?