TRADING Basics
Indicator Insight:
BY ACTIVE TRADER STAFF
Bollinger Bands
FIGURE 1 BOLLINGER BANDS VS. MOVING AVERAGE ENVELOPE While moving average envelopes (top chart) move higher or lower together, Bollinger Bands can move in opposite directions (lower chart).
B
S&P index-tracking stock (SPY), daily
92
ollinger Bands are a type of 91 Moving average envelope 90 trading “envelope” consisting moves in tandem 89 of lines plotted above and 88 below a moving average 87 designed to capture a market’s typical 86 85 price fluctuations. 84 The indicator is similar in concept to 83 the moving average envelope (see 82 81 Indicator Insight, Active Trader 80 September 2002, p. 88), with an impor79 tant difference: While moving average envelopes plot lines a fixed percentage 92 above and below the average (typically 91 Bollinger Bands expand and contract 90 three percent above and below a 21-day with the market volatility 89 simple moving average), Bollinger 88 Bands use a statistical measurement of 87 86 the closing prices called standard devia 85 tion (see the next section) to determine 84 how far above and below the moving 83 average the lines are placed. 82 81 As a result, while the upper and lower 80 lines of a moving average envelope 79 always move in tandem (Figure 1, top 10 18 24 3 10 17 24 31 chart), Bollinger Bands expand (i.e., the February March April 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, Middle line = 20-period simple moving average of bottom chart). closing prices Bollinger Bands were created by John Bollinger, CFA, CMT, Lower band = 20-period simple moving average the president and founder of Bollinger Capital Management 2 standard deviations (see Active Trader, April 2003, p. 60). Standard deviation is a statistical calculation that measures Calculation how far values deviate from an average value — in this case, The classic approach to this indicator is to place the upper and how far prices stray from a 20-day moving average. The proplower Bollinger Bands two standard deviations above and er use of standard deviation calls for a sample of at least 30 below a 20-period moving average. observations, in which case, statistically, 95 percent of values will fall within two standard deviations of the average value. Upper band = 20-period simple moving average + Because Bollinger Bands typically use just 20 days of closing 2 standard deviations prices, the bands will generally encompass 88 to 89 percent of 74
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
28.0
Bollinger Bands are wide 27.5 27.0 26.5 Bollinger Bands narrow
26.0 25.5 25.0
the price action. (To learn more about standard deviation, see the Web Extra for this article at www.activetradermag.com between June 10 and June 30, 2003.)
A nice trend run follows the narrow Bollinger Bands
24.5 24.0 23.5
Interpretation and use Bollinger Bands provide two important pieces of information: first, whether volatility is high or low, which can be determined by 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-February, the Bollinger Bands were running at a nearly $3.50 differential. Then, as the market moved into a lower-volatility trading range in February, the Bollinger 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 overbought 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 provide context for the Bollinger Band signals. continued on p. 79
23.0
Bollinger Bands are wide 6 13 2003
21
27
3 10 February
18
24
3 10 March
17
24
31 7 April
Source: MetaStock
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 (BBBY), daily
40 39 38 37 36 35 34 33 Support point
32 31 30 29
Head fake Money Flow Index
Bullish readings greater than 50
80 70 60 50 40 30
Divergence December
2003
February
March
April
Source: MetaStock
ACTIVE TRADER • July 2003 • www.activetradermag.com
75
Indicator Insight continued from p. 75 A basic technique is to 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 Bollinger Bands and the Money Flow Index (MFI), which is similar to the relative strength index oscillator (RSI, see
lied sharply, driving the MFI into bullish territory (readings above 50). The stock advanced an additional $6. The successive tags of the upper Bollinger Band following the head fake were a sign of strength — although the overbought condition they indicated created a temporary pullback to the moving average,
FIGURE 4 THE 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
92 91 90
Downtrend, moving average acts as resistance
89 88 87 86 85 84 83
Uptrend, moving average acts as support
82 81 80 79
3 10 February
18
24
3 10 March
17
24
31 7 April
14
78
Source: MetaStock
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 narrowing of the Bollinger Bands. During late February, the Bollinger Bands narrowed and the market fell to a new low. However, price quickly reversed and ral-
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. Conversely, during a strong downtrend, price generally fluctuates between the moving average and the lower band. For example, in Figure 4 (above) the
ACTIVE TRADER • July 2003 • www.activetradermag.com
market traded temporarily above the falling 20-day moving average (the mid dle band) and then fell back to the lower band. Then, when the trend reversed, there were buying opportunities where the price temporarily fell below the rising 20-day moving average.
Key points 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,” 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.). Using confirming technical tools or chart patterns is an important element 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.
Bottom line By providing a framework designed to 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 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 79
