What are Bollinger Bands and how do you use them in trading?
In this article, John Bollinger, CFA, CMT gives traders and investors insights around why Bollinger Bands are popular technical indicators, as well as how to use them along with their derivatives, the %B and Bandwidth indicators.
What Are Bollinger Bands?
Bollinger Bands present a framework for determining whether prices are high or low on a relative basis. Bollinger Bands and the primary tools derived from them, %B and Bandwidth, are tools based on first principles of the market that can be used to aid pattern recognition, to build rigorous trading systems, to create individualised analytical approaches for the financial markets, and for much, much more.
Bollinger Bands are a technical analysis tool, specifically a type of trading band or envelope. Trading bands are usually built around a measure of central tendency such as a moving average, while envelopes encompass the price structure without a clearly defined central focus, perhaps by reference to highs and lows, or via cyclic analysis. Over the years there have been many variations on bands and envelopes, some of which are still in use.
Today the most popular approaches to trading bands are Donchian, Keltner, percentage, and, of course, Bollinger Bands.
Why did I develop Bollinger Bands?
When I started working in the markets percentage bands were the most popular choice. Percentage bands are quite simple, a moving average shifted up and down by a user-specified percent. For example, at any given time a 7% band consists of a base moving average, an upper curve at 107% of the base and a lower curve at 93% of the base. Percentage bands had the decided advantage at the time of being easy to chart by hand.
I started working in the markets full time in 1980. I was mainly trading options and becoming very interested in technical analysis. We used percentage bands and compared price action within the bands to the action of supply-demand tools like David Bostian's Intraday Intensity to create trading systems.
If the price touched the upper band without confirmation from the oscillator, it was a sell setup and a similarly unconfirmed tag of the lower band was a buy setup. It was a good system, but it had a critical issue: The percentage bands needed to be adjusted over time to keep them germane to the price structure. Any time an adjustment like that is made the door is opened for emotions to enter into the analytical process. Depending on the trader’s feelings about the prospects for the market they may tweak the bands appropriately to support their thesis.
We tried hard to prevent our biases from getting the best of us, including implementing reset rules like lookbacks with some success, but what we really needed was an adaptive mechanism that automated our decisions.
For my option trading I had built some volatility models in an early spreadsheet program called SuperCalc. One day I copied a volatility formula down a column of data and noticed that volatility was changing over time. That was not intuitively correct at the time, as volatility was viewed as a static quantity, a property of a security.
We thought that if volatility changed at all it did so only in a very long-term sense, over the life cycle of a company for example. But seeing volatility dynamically change levels over time opened a window for innovation, I wondered if volatility itself couldn't be used to set the width of trading bands.
I experimented with a variety of different measures of volatility, and settled on the Bollinger Band formulation we know today, an n-period moving average with bands drawn above and below at intervals determined by a multiple of population standard deviation.
The defaults I used then were 20 periods for the moving average, with the bands set at plus and minus two standard deviations of the same data used for the average, and 35 years later, those are still the defaults that I prefer.
How do Bollinger Bands work?
Bollinger Bands are curves drawn in and around the price structure usually consisting of a moving average (the middle band), an upper band, and a lower band that answer the question as to whether prices are high or low on a relative basis. Bollinger Bands work best when the middle band is chosen to reflect the intermediate-term trend, so that trend information is effectively combined with relative price level information.
From a practical application perspective, Bollinger Bands are extremely flexible. For example, they can be helpful in diagnosing technical patterns like W bottoms and M tops, as well as some Bollinger Band specific patterns like the Squeeze and the Head Fake, which have become very popular with traders. Indeed, there are potentially as many uses as there are traders.
Bollinger Bands summed up
At the end of the day, Bollinger Bands are tools. They can be used in the creation of your own trading systems and approaches. They are used by traders around the world and across many different markets in a wide array of approaches. Because they are tools, not a system, and because BB applications are so diverse, they continue to work year after year as they are adapted and applied in new ways.
IG’s guide on how to use Bollinger Bands in trading
The following is a commentary by IG senior market analyst Shaun Murison
Bollinger Bands are a popular tool used in breakout trading.
Breakouts – Bollinger Squeeze
When the upper and lower Bollinger Bands are moving towards each other, or the distance between the upper and lower bands is narrow (on a relative basis), it is a suggestion that the market under review is consolidating.
A consolidation phase suggests that the market is non-directional for the time being and now rangebound in nature. The narrow or narrowing Bollinger Bands will essentially move closer to the price and at some stage appear to be ‘Squeezing’ the price. It is at this stage that breakout traders might pay attention.
The highs and lows of a consolidation may be marked with trend lines. A price moves above the high of the consolidation would consider an upside breakout, while a price close below the low of the consolidation would consider a downside breakout. The Bollinger Bands can now be used as a filter for these breakout trade scenarios.
An upside breakout might be confirmed with a price close above the resistance trend line as well as above the upper Bollinger Band. A downside breakout might be confirmed with a price close below the support trend line as well as below the lower Bollinger Band.
It is also preferable to see the upper and lower band starting to widen in a breakout scenario. The widening of the bands suggests an increase in volatility to confirm the move out of a consolidation and into a new trend.
The narrow bands suggest a period of low volatility often associated with a sideways market environment (consolidation). Widening bands suggest an increase in volatility often associated with a trending market environment. Volatility is considered cyclical in nature in that a period of low volatility is a precursor to high volatility and vice versa. Combining price breakouts with Bollinger Bands is often referred to as a volatility breakout strategy. The strategy whereby we wait for a narrowing of Bollinger Bands as a precursor to a breakout is known as a Bollinger ‘Squeeze’.
For more trading strategies relating, please see IG senior market analyst Shaun Murison’s articles.
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