A Fortnightly Newsletter
01st February 2012
Technical Analysis

BOLLINGER BANDS- Telling you when to buy and when to sell.

Imagine having Aladdin’s magic lamp, and having the genie guide you through the chaos of buying and selling in capital markets!

On a more realistic note, it would really be a boon if somebody or something can give intimation about when to buy and when to sell, when are the tops forming and when the bottoms are rounding up. Though this is quite difficult but Bollinger Bands can assist you in getting those signals.

What are Bollinger bands?

Bollinger Bands are a technical analysis tool invented by John Bollinger in the 1980s. Having evolved from the concept of trading bands, Bollinger Bands can be used to measure the highness or lowness of the price relative to previous trades.

Bollinger Bands consist of:

  • A middle band being an N-period simple moving average(MA)(Moving average means a simple average of the closing prices of N-period)
  • An upper band at K times an N-period standard deviation above the middle band (MA+K*sigma)
  • A lower band at K times an N-period standard deviation below the middle band (MA-K*sigma)

    (Sigma stands for standard deviation which shows the deviation from the average and is a measure of risk measuring volatility)

    Typical values for N and K are 20 and 2, respectively. The default choice for the average is a simple moving average, but other types of averages can be employed. Usually the same period is used for both the middle band and the calculation of standard deviation.

    Bollinger Bands Technical Analysis
    Pic Reference: Bollingerbands.com

Purpose of Bollinger bands
The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition, prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions.

How to read signals?

The use of Bollinger Bands varies widely among traders. Some traders buy when price touches the lower Bollinger Band and exit when price touches the moving average in the center of the bands. Other traders buy when price breaks above the upper Bollinger Band or sell when price falls below the lower Bollinger Band.

When the bands lie close together a period of low volatility in stock price is indicated. When they are far apart a period of high volatility in price is indicated. When the bands have only a slight slope and lie approximately parallel for an extended time the price of a stock will be found to oscillate up and down between the bands as though in a channel.

Traders are often inclined to use Bollinger Bands with other indicators to see if there is confirmation. In particular, Bollinger Bands are often coupled with a indicators like chart patterns or trend lines; if these indicators confirm the recommendation of the Bollinger Bands, the trader will have greater evidence that what the Bands forecast is correct.


Statistical significance-
Security prices do not follow normal distribution in statistics, thus we cannot find 95% of the data within the band (a characteristic of normal distribution where 95% of data is within 2 standard deviation or within the band) and how data is within the band is the function of assets volatility (standard deviation).


13 Rules to remember with Bollinger bands
  1. Bollinger Bands provide a relative definition of high and low.


  2. That relative definition can be used to compare price action and indicator to arrive at rigorous buy and sell decisions.


  3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc.


  4. Volatility and trend have already been deployed in the construction of Bollinger Bands, so their use for confirmation of price action is not recommended.


  5. The indicators used for confirmation should not be directly related to one another. Two indicators from the same category do not increase confirmation.


  6. Bollinger Bands can also be used to clarify pure price patterns such as M-type; tops and W-type bottoms, momentum shifts, etc.


  7. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.


  8. Close outside the Bollinger Bands can be a continuation signal, not reversal signal, as is demonstrated by the use of Bollinger Bands in some very successful volatility-breakout system


  9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the bandwidth are just that, defaults. The actual parameters needed for any given market/task may be different.


  10. The average deployed should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.


  11. If the average is lengthened the number of standard deviations needs to be increased simultaneously; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced; from 2 at 20 periods, to 1.9 at 10 periods.


  12. Bollinger Bands are based upon a simple moving average. This is because a simple moving average is used in the standard deviation calculation and we wish to be logically consistent.


  13. Be careful about making statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The sample size in most deployments of Bollinger Bands is too small for statistical significance and the distributions involved are rarely normal.


References:

1.) Achelis, Steve. Technical Analysis from A to Z (pp. 71–73). Irwin, 1995.
2.) Murphy, John J. Technical Analysis of the Financial Markets (pp. 209–211). New York Institute of Finance, 1999
3.) Bollingerband.com

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