A popular indicator, Bollinger Bands are similar to Envelopes. Bollinger Bands are a type of trading band used to determine the upper and lower trading boundaries of a security. Whereas Envelopes are plotted at a set percentage above and below a central Moving Average (and are therefore always parallel to the Moving Average), Bollinger Bands are plotted at a set standard deviation above and below the Moving Average.

The standard deviation of the price is a measure of its volatility, so the distance of the Bollinger Bands from the Moving Average varies with price volatility. The bands widen during periods of high volatility, when there are sharp changes in price, and become narrower during more stable periods.

John Bollinger created Bollinger Bands and commonly set the bands at 2 standard deviations away from the Moving Average. In the Bourse, the band offsets are adjusted to enclose about 90% of price activity, with about 10% slipping either above or below the Bollinger Bands. (That is, the band offset is about 1.65 standard deviations.) This allows for a more accurate assessment of the true trading range of the underlying security.

• Bollinger Bands Charts

  Interpretation

  Bollinger Bands can be used to compare volatility and relative price levels over time. Volatility is important for options players since options prices are cheaper when volatility is low.

  Since Bollinger Bands define the upper and lower boundaries of a security's normal trading range, movement towards the upper band can be interpreted as over-buying (paying more than the security is worth) and movement towards the lower band as over-selling. The reasoning behind this is that market excitement will often push prices to extremes, before stabilising to more realistic levels. Basically:

  • If the price moves above the upper band, this can be considered a sell signal (go short).
  • If the price moves below the lower band, this can be considered a buy signal (go long).

  When the price penetrates the bands, confirming evidence is required to determine if the trend is expected to continue or will reverse. Prices penetrating outside the bands suggest a continuation of the current trend. Bottoms and tops made outside the bands followed by bottoms and tops made within the bands suggest a reversal in the trend. Bollinger Bands do not indicate the future direction of prices, so other technical indicators should be used to help determine the direction of a potential breakout.

  Advantages and Disadvantages

  Though identifying periods when prices are at an extreme (and perhaps unsustainable) level is useful, note that Bollinger Bands only indicate that prices are high or low on a relative basis. Buy and sell signals are, therefore, not necessarily given when prices penetrate the upper or lower bands. Securities will often shift between periods of high and low volatility. A security can become over-bought or over-sold for an extended period, before reversing, so it is important that an appropriate term is chosen for the data. For this reason, look for evidence of price weakness/strength before expecting a reversal. Significant consideration should be given to the price momentum.

  Sharp price changes tend to occur after the bands tighten and volatility is low. Identifying a period of low volatility can serve as an alert to monitor the price action of a security.

  Tips

  • Bollinger Bands should cover most of the price action. If prices appear to penetrate the outer bands too often, then a longer term may be required. If prices rarely touch the outer bands, then a shorter term may be required. Mr. Bollinger recommends using 20 for the term. He has also found that terms of less then 10 do not work very well.
  • Bollinger Bands are often used in with Relative Strength Index, Momentum, MACD, Commodity Channel Index and Rate of Change indicators. Divergence between Bollinger bands and other indicators show potential action points.

  References

  Bollinger, John, CMT President, Bollinger Capital Management, Inc.
  P.O. Box 3358 Manhattan Beach, CA 90266 (310) 798-8855.