In my last Sleuth column, I discussed Bollinger Bands, an indicator popular among traders and technically versed investors.  I described the concept behind Bollinger Bands and how they are constructed.  Today, I’d like to tell you about some implications you can draw from this technical tool and a couple of ways you can use them to augment your trading or investing efforts.

In order to effectively use Bollinger Bands, it’s helpful to understand what they reflect.  In my last Technical Tuesday column, I mentioned that Bollinger Bands serve two functions.  First, they inform you of the current volatility level of a stock, exchange traded fund (ETF), or index.  Second, the bands mark for you the current trading range of the security you have under the technical microscope.

Now, it’s important to remember that Bollinger Bands do not indicate which direction a stock or index is headed.  For that you can use momentum or trend indicators, moving averages, support and resistance lines, or chart patterns.  When you add Bollinger Bands to your analysis, you can also make a more astute assessment of the chances of a strong move taking place and the profit potential in that move.

With that in mind, let’s take a look at some ways you can use Bollinger Bands to enhance your trading or investing performance.  First of all, how can knowledge of a stock or index’s volatility help you?

Knowledge of volatility allows you to better assess the risk and reward in a trade or investment.  For example, if a stock is bouncing back and forth between its upper and lower Bollinger Bands, you can gauge how large a move to expect.  Similarly, knowledge of volatility can assist you in gauging the risk of a move against you in a stock or ETF you already own. 

But volatility also can tell you other things.  Narrow bands indicate that a stock or index is trading within a tight trading range.  Think about that for a second.  Now, consider that stocks and indices move from trading in trends to trading in trading ranges and back again. 

It is true that — since Bollinger Bands are adaptive and change in relation to recent prices — narrow bands reflect a stock or index that has been trading within a small range.  But since stocks and indices frequently shift back and forth between trading ranges and trends, contracting Bollinger Bands can also provide you advance notice that the commencement of a new trend is imminent.

How does this work?  In the textbook case, the Bollinger Bands of the stock or index in a trading range will converge, or move closer together.  Ideally, both of the bands will curve toward each other, forming a very tight channel.  Then, suddenly the stock or index makes a strong directional move, bursting through one of the bands.

So, do you then take a position in the direction of that dramatic move?  Not necessarily.  You see, the first move out of extremely narrow Bollinger Bands is often a false one.  Often, that initial thrust outside of one of the bands will be immediately reversed.  It is then that a trend frequently begins — in the direction opposite the initial move.

How do you know if that first strong move outside the narrow bands is a fake-out?  You don’t.  But that’s where the benefit using other technical tools — in conjunction with Bollinger Bands — comes in.  Remember, I said earlier that Bollinger Bands do not tell you about the direction of a stock or index.

If you use a moving average, support or resistance lines, or a chart pattern to help you discern the most probable direction of a stock or index, when you see severely contracting Bollinger Bands, you will have a greater degree of conviction in the move you are anticipating.  Not only that, but the added confirmation provided by the contracting Bollinger Bands will have just shifted the odds of success a little further in your favor.

Now, let’s consider one other point concerning volatility.  In my last Technical Tuesday column, I said it is commonly believed that when a stock or index trades up to its upper Bollinger Band, it becomes overbought — and due to fall.  And when a stock or index trades down to its lower Bollinger Band, it is oversold and set to rally. 

I then said that this common conception is true some of the time and not others.  It is when a stock or index is in a trading range that this common belief holds true.  So, if a stock or index has just entered a trading range, you could expect to see a move from one Bollinger Band to the other.  Again, use one or more indicators, averages, lines, or patterns to confirm that the stock or index is in a trading range.

What is particularly attractive about using Bollinger Bands with a stock or index entering a trading range is that — since a trend will have just terminated — the bands will still be relatively far apart.  Thus, the range you are attempting to exploit is relatively wide — with an opportunity to nail down a larger profit than at a later stage in the trading range, when the distance between the Bollinger Bands is narrower.

We’ve talked about how to use Bollinger Bands when a stock or index is caught in a trading range, but what about when that stock or index is in a trend?  Here’s how Bollinger Bands can help you in this situation.

First, if you have entered a position near one of the Bollinger Bands prior to a big move — i.e. you are long a stock, ETF, or call option near the lower Bollinger Band, or short a stock, ETF, or long a put option near the upper Bollinger Band — look for a move to the centerline.  If your stock or ETF continues through the centerline, use the Bollinger Band on the other side as your target.

So far this sounds a lot like a trading range, doesn’t it?  It’s not.  You see, a stock or index trading in a strong trend can go outside the band and remain there for quite some time.  For example, a strongly trending stock or index can pierce through its upper Bollinger Band and continue to trade there for a long while.  Similarly, the reverse is true for a stock or index locked in a major downtrend. 

In other words, this is where the common conception about how to use Bollinger Bands is wrong.  If you exit your position when that trending stock or index first touches that Bollinger Band you could cost yourself significant profits.

One other situation that can occur in a strong trend is that a stock or index can trade all the way from one Bollinger Band to the other and then hover around that far Bollinger Band for a period of time.  Here again, you don’t want to exit too soon — on the mistaken assumption that a stock or index simply bounces between its upper and lower bands.  Otherwise, you could be cutting short an opportunity to maximize a profitable position.

I’d like to touch upon one last point.  You can often enter a favorable position in a trend by waiting for a divergence between the price of a stock or index and the position of the Bollinger Bands.  For example, if you are interested in purchasing a stock and that stock trades below its lower Bollinger Band, wait for that stock to make another low inside the lower band. 

It doesn’t matter whether that second low is higher or lower than the first one.  What matters is that the second low — unlike the first one — is inside the lower band.  This is considered a bullish divergence — and a good trade setup.  The converse is true when seeking to establish a short position.  Wait for the stock or index to make a high inside the upper Bollinger Band — after a prior high above that upper band — before entering your position.

As you can see, Bollinger Bands offer the astute technician some important information about the character of a stock or index.  Although they can’t tell you a stock or index’s likely future direction, Bollinger Bands can provide some choice clues about the probable length of the next move or keep you from exiting a profitable position too soon.  So, the next time you contemplate a new position — or scratch your head over an old one — before you act, remember to strike up the bands.

Trade well, 

Mark Bail
April 11, 2006

Strike Up the Bands was originally featured in the Penny Sleuth.

In recent weeks, I’ve talked about utilities being an area of the market that appears weak, despite the current general overall strength.  I came across the perceived weakness in utilities by reaching into my technical toolbox and pulling out some of my trusty implements.

It’s been awhile since I’ve written about the tools of the trade I use to locate the best — and worst — places to invest in equities.  So, let’s open the toolbox and see what might aid your efforts to search for profits in the market mines, shall we?

If you have been watching the markets closely, you might have noticed some unusual recent trading patterns.  The market has been up one day and down the next.  Most of the broad-based indices have moved higher — and are in up-trends.  But those indices have taken a very unusual road to higher prices.

Normally, when the stock market is in rally mode you see a series of strong up moves — with one day following through on the next.  Prices then pull back — as volume contracts — and we see the inevitable short-term “profit-taking.”  The rally then resumes.

That hasn’t been the case recently.  What we’ve seen is more of a churning, uncertain environment.  The majority of stocks have risen, but the averages are advancing in an uncertain, stutter-step fashion — without the normal follow-through. 

So, while today’s equities climate lacks the clean, powerful moves we like to see, we sure have seen a lot of volatility.  The market indices have moved in wide swings — just not in a consistent direction.  The back and filling in the averages has obscured the wild daily swings that have taken place.

That got me to thinking about volatility and the tools you can use to study those trading swings.  For if you can put the seemingly erratic day-to-day swings into some sort of larger context, wouldn’t you be better off?  And what is the likelihood that the current trading patterns will continue for the next few days or weeks?  Wouldn’t it be helpful if you could gauge the odds of a continuation of current price behavior — or be able to anticipate a change in that behavior?  Of course it would.

Now, there are several different ways to measure volatility — or the movement between high and low prices — and divine its meaning within the larger context of overall price change.  One way to look at volatility and price swings is to use one of the best-known technical indicators — Bollinger Bands.

Bollinger Bands are not a part of the trading system we use in MST Trader.  But given that MST Trader is an options trading service — with heightened importance placed on volatility and short-term price movements — I often look at Bollinger Bands to attempt to gain an additional edge in the trading wars.

But you don’t need to be an options trader — or even a short-term stock trader — for Bollinger Bands to improve your experience in the financial markets.  Bollinger Bands can assist you if you have an intermediate-term investing time frame — or even a long-term outlook.

Today, I’ll tell you what Bollinger Bands are and how they are constructed.  In my next Technical Tuesday column, I’ll mention a few ways that you can put Bollinger Bands to work to enhance your trading or investment analysis.

As you might have gleaned from its name, Bollinger Bands were developed by the well-known market technician John Bollinger.  Bollinger Bands are primarily used to evaluate the volatility of a stock or market index over a period of time.  They are particularly useful when comparing the volatility of a stock or index to its relative price levels.

Bollinger Bands consist of three lines — two trading bands that surround, or envelope, a centerline.  The centerline of the indicator is a moving average.  Typically, a 20-day simple moving average is used to construct the indicator’s centerline.  However, you can substitute other inputs, depending upon the time frame you are considering. 

For instance, Bollinger says the 20-day moving average is a good centerline to use for an intermediate time frame.  However, if you are attempting to analyze a particularly short-term trend, you might find that a shorter period moving average would work better for you.  In fact, Bollinger has said that a 10-day simple moving average often works well for shorter time periods.  Conversely, Bollinger suggests that you might be better off using a longer moving average for your Bollinger Bands centerline — such as a 50-day simple moving average — if you are trading or investing in a long-term time frame.

The major point to remember is that — as with many other technical indicators — the input you use should fit the time frame of your trading or investment program.  So, although the 20-day simple moving average is the default input used for the Bollinger Bands centerline in most trading software packages and charting websites, you should experiment with different time periods and find the one that works best for you.

How can you tell what works best?  To answer that question, you need to explore the other facet of this useful indicator — the trading bands. 

Prior to the creation of Bollinger Bands, some traders and investors used trading envelopes to place lines at a fixed percentage distance above and below a moving average.  In developing the Bollinger Bands indicator, John Bollinger decided to substitute the concept of a standard deviation for the fixed percentage.

For those of you who do not remember your high school mathematics, standard deviation is an arithmetic calculation.  In the context of technical analysis, the standard deviation concept is used to estimate the percentage of a stock or index’s prices that fall within a certain range.  For example, 68.3% of a stock or index’s prices would be expected to fall within trading bands that are located one standard deviation above and below the moving average centerline.

The most commonly used input for the Bollinger Bands standard deviation calculation is two.  That means that Bollinger Bands constructed with trading bands set two standard deviations above and below the centerline means would be expected to capture 95.2% of the stock or index prices you are scrutinizing.  Just like the centerline, you could experiment with your standard deviation input — e.g. 1.5 for a short-term time period and perhaps 2.5 for a longer time frame.

The point behind using a standard deviation calculation to set trading bands — rather than a fixed percentage — is that the trading bands are dynamically related to both the recent price movement and the level of volatility of the stock or index you are examining.  Since, by definition, the bands capture a certain percentage of prices inside of them, those bands must adjust to the current trading patterns by contacting or expanding according to those prices.  That’s the beauty of Bollinger Bands — they are adaptive, not static.

The contraction and expansion of the bands serves two purposes.  First, by constantly adjusting according to the most recent prices, the bands portray the up-to-date, likely expected trading range.  Second, the width of those trading bands illustrates the current volatility level of the stock or index under study.

It is often thought that when a stock or index trades up to its upper Bollinger Band, it has become overbought — and ripe for a fall.  And when that same stock or index falls down and touches — or even penetrates — its lower Bollinger Band, it is oversold and ready to bounce. 

Like most trading and investing concepts, things are not quite so cut-and-dried.  That common conception is sometimes true.  And sometimes it’s not. 

The proper uses of Bollinger Bands are a bit more complex than typically thought.  Like most indicators, Bollinger Bands are most effective when used in conjunction with other market technical tools.  In my next Technical Tuesday column, I’ll describe a few ways these interesting, adaptive bands can help you during these volatile times. 

Trade well,

Mark Bail

A Tool for These Volatile Times was originally featured in the Penny Sleuth.