TRADING Basics

Indicator Insight: Bollinger Bands

BY ACTIVE TRADER STAFF 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
trading “envelope” consisting 90
moves in tandem 89
of lines plotted above and
88
below a moving average 87
designed to capture a market’s typical 86
price fluctuations. 85
84
The indicator is similar in concept to 83
the moving average envelope (see 82
Indicator Insight, Active Trader 81
September 2002, p. 88), with an impor- 80
79
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
the closing prices called standard devia - 86
tion (see the next section) to determine 85
84
how far above and below the moving 83
average the lines are placed. 82
As a result, while the upper and lower 81
lines of a moving average envelope 80
79
always move in tandem (Figure 1, top
chart), Bollinger Bands expand (i.e., the 10 18 24 3 10 17 24 31
top band can rise while the bottom band February March April
falls) during periods of increasing mar- Source: 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 prop-
lower 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
A nice trend run
standard deviation, see the Web Extra follows the narrow 24.5
for this article at www.activetrader- Bollinger Bands
mag.com between June 10 and June 30, 24.0
2003.)
23.5
Interpretation and use
Bollinger Bands provide two important 23.0
pieces of information: first, whether Bollinger Bands are wide
volatility is high or low, which can be 6 13 21 27 3 10 18 24 3 10 17 24 31 7
determined by measuring the difference 2003 February March April
or the width between the upper and Source: MetaStock
lower band; and second, whether prices
are high or low relative to past prices as FIGURE 3 HEAD FAKES
well as within the context of the
Bollinger Bands themselves. Contracting Bollinger Bands can sometimes lead to false breakouts. Here,
Watching for low-volatility condi- new lows established after the bands contracted appear to signal the start
tions is a well-known trading technique, of a downtrend in early March. However, it was just a “head fake” and price
because low volatility often precedes quickly reversed.
high-volatility trend runs. For example,
Bed, Bath & Beyond (BBBY), daily 40
Figure 2 shows the Nasdaq 100 index-
tracking stock (QQQ). During January 39
and into mid-February, the Bollinger 38
Bands were running at a nearly $3.50
37
differential. Then, as the market moved
into a lower-volatility trading range in 36
February, the Bollinger Bands narrowed 35
to a $2 difference. This volatility con- 34
traction was a sign to look for an emerg-
33
ing trend move. In this case, the market
broke through resistance at $25.50, and 32
Support point
sprinted back to the January highs. 31
Tags of the upper and lower Bollinger 30
Bands can indicate temporary over-
Head fake 29
bought and oversold conditions, but
Bollinger stresses these events are not Money Flow Index
automatic reversal trade signals. In a Bullish readings 80
greater than 50 70
strong uptrend, for example, price can
repeatedly tag the upper Bollinger Band, 60
similar to the way an oscillator will stay 50
above its overbought threshold in the 40
same circumstances. As a result, other Divergence 30
information must be consulted to provide December 2003 February March April
context for the Bollinger Band signals.
Source: MetaStock
continued on p. 79

ACTIVE TRADER • July 2003 • www.activetradermag.com 75

Indicator Insight continued from p. 75
A basic technique is to combine lied sharply, driving the MFI into bullish
Bollinger Bands with another indicator. territory (readings above 50). The stock
Bollinger, for example, considers volume advanced an additional $6. The succes-
analysis to be a valuable aid. Figure 3 (p. sive tags of the upper Bollinger Band fol-
75) is Bed Bath and Beyond (BBBY) with lowing the head fake were a sign of
Bollinger Bands and the Money Flow strength — although the overbought
Index (MFI), which is similar to the rela- condition they indicated created a tem-
tive strength index oscillator (RSI, see porary 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 89
acts as resistance
88
87
86
85
84
Uptrend, 83
moving average
acts as support 82
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 ris-
ing 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., 60-
minute 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 oscil-
lators. Combine volume, an oscillator
and the Bollinger Bands for a more-
rounded market perspective.

3 10 18 24 3 10
February March
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 phenome-
non Bollinger refers to as the “head fake”
— a false breakout following a narrow-
ing 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-
81
80
79
78
17 24 31 7 14
April
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
Bottom line
By providing a framework designed to
contain nearly 90 percent of price fluctu-
ations, 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 drop-
ping (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 inter-
preted 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

ACTIVE TRADER • July 2003 • www.activetradermag.com 79