Investing with Bollinger Bands

This article was written some years ago, but is very relevant to today. The charts used to illustrate the text are now somewhat dated, but still relevant for the present purpose of teaching a technique.

As moving averages became more popular, some analysts noticed that when prices were moving upward, they had a tendency to rise only so far above the moving average. When prices were falling they tended to fall only so far below the moving average. How far they rose or fell seemed to vary from stock to stock and also from time to time. However, the tendency was so consistent that it could be useful to both traders and investors.

These early analysts hit on the idea of drawing lines a certain percentage of the moving average above and below the moving average line. They selected the percentage stock-by-stock so that it seemed to catch most of the price action on the chart, typically 90% or more of the price action.

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Chart 1: Daily Line Chart of GWA International with a 22-day Moving Average and 5% Bands

The result was something like Chart 1, where we have a daily line chart, on which is drawn a 22-day moving average, with 5% bands above and below it. 5% was chosen by trial and error.

John Bollinger, a market analyst for CNBC/Financial News Network came up with an important improvement on this idea, which he called Bollinger Bands. Bollinger reasoned that it would be good if the selection of the band width was not arbitrary or found by trial and error. Having found a solution to that problem, he then discovered some other interesting properties of his new bands.

What Bollinger did was to make the bands, not a percentage of the moving average, but to place them at standard deviations of the moving average. This meant that the bands would adjust to the volatility of the market. So, when the market swung widely, the bands would open up and when the market became quiet, the bands would contract.

Chart 2 shows the same stock and period as was used in Chart 1, with Bollinger’s standard setting of a 20-day moving average and the bands set at 2 standard deviations. Notice how, at the start of the chart, the price is moving upward in a tight trend. The Bollinger Bands gradually contract. Then, the price swings sharply downward and the Bollinger Bands widen rapidly to accommodate the increased volatility. Work your way through the chart making the comparison between the volatility of the price swings and the Bollinger Bands, for a good appreciation of this key property of Bollinger’s idea.

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Chart 1: Daily line Chart of GWA International with Bollinger Bands (20-day MA and Bands 2 Standard Deviations)

In Bollinger’s latest writing on the subject, his book Bollinger on Bollinger Bands, he revises some of his earlier ideas in the light of subsequent testing and experience. He suggests that different investors and traders should vary the settings somewhat; like this:

For intermediate term trends, use a 20-day moving average with bands at 2 standard deviations

For short term trends, use a 10-day moving average with bands at 1.9 standard deviations

For long term trends, use a 50-day moving average with bands at 2.1 standard deviations

Unlike the other indicators discussed earlier, Bollinger Bands are not designed to give trading signals as such. Instead, they simply give important indications that are used to confirm other price analysis or indicators.

Indication 1: Possible Explosive Move The first indication is a simple one, which we have already met when we discussed multiple moving averages. This is that sharp trending moves often start from periods of very quiet price trading. The expression of this in Bollinger Bands is that explosive trending moves tend to follow significant contraction of the bands. The one caveat on this is that sometimes there is a misleading initial move, what American sport commentators call a “head fake”, in the opposite direction.

Several examples of this indication can be seen in Chart 3. Two are very clear. At A we see the bands contract significantly. This is followed by a very strong uptrend. At B, the bands come together very

tightly. The initial move is up (the head fake), which pulls in buyers, who are then slaughtered by a strong shake-out downwards.

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Chart 3: Daily Bar Chart of Select Harvests With Bollinger Bands (20-day MA, Bands 2SD)

Traders and investors should have little problem using this indication. It flashes a big signal to get ready to act quickly on a sharp move.

Indication 2: Bands as Targets The second indication is also useful, especially for short term traders. It is that price moves starting at one band will tend to travel all the way to the other band. There are several good examples in Chart 3. At the start of the chart the price tracks up along the upper band. Then it moves away from the upper band and makes its way all the way to the lower band. You should have no problem seeing other examples on Chart 3 and on the other Bollinger Bands charts in this article.

Traders and investors should find this very useful in judging when to take profits on upswings and when to buy into trends on corrections.

Indication 3: Extreme Strength The third indication is of great importance to traders and investors. They often face the problem of whether to take profits on a sharp move, or to stay with the move. This indication is that a move outside the bands suggests, not exhaustion, but strength. It implies continuation of the move. This indication is cancelled only when the price immediately reverses back into the bands.

Chart 4 shows some good examples that might have been used by an investor on a weekly chart of Select Harvests. The chart uses a 50-week moving average and the bands are at 2.1 standard deviations.

At A and at B, the price breaks above the upper band. In both cases, a very strong and persistent trend unfolds, mostly near the upper band. This could have been very useful in keeping and investor in these trends. The very prominent upward spike prior to B is also an example of where the price

drove way outside the bands and then fell back inside them quite quickly. A prolonged sideways period followed.

At C and at D, the price breaks above the upper band and falls back inside it quite quickly. In the first case, a weak uptrend unfolds, but in the second case a sharp correction follows.

Clearly, this property of Bollinger Bands cannot be used in isolation. Other indicators or chart analysis should be used to time actions. However, the Bollinger Bands give important advance warning of the possibilities.

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Chart 4: Weekly Bar Chart of Select Harvests With Bollinger Bands (50-week MA, Bands 2.1SD)

Indication 4: Failure Swing In our discussion of Relative Strength Index (RSI) , we described what Welles Wilder called a failure swing. This was when the RSI made a peak in overbought territory and then a lower peak. This same idea was noticed by Bollinger with price and the upper band. When the price has been trending upwards and makes a peak outside the upper band and the next peak is made inside the band, it is likely that we have seen the last peak of the trending move. The same will apply in reverse at the lower band in a downtrend.

Chart 5 shows an example on a daily bar chart of Aeris Technologies using Bollinger’s settings for a short term trend. In March a strong uptrend begins and carries Aeris significantly higher into April. At A there is peak above the upper band. The next peak is at B, which is well inside the bands. This was an excellent warning of the significant correction, which may turn out to be a downtrend. In this case, indication 1 was useful in conjunction with Indication 4. The narrowing of the bands after B, should have warned traders to be on high alert for a possible sharp reversal.

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Key Thoughts on Indicators (articles headed “Investing with”):

1. Use Trend-following indicators to trade trends.

2. However, trend-following indicators only give good results in strong and sustained trends.

3. Use Momentum oscillators to trade sideways markets and to buy into well-established trends.

4. Most trend-following indicators lag behind turns in the market. Do not expect them to pick the exact high point of an uptrend or to signal you to buy at the exact lowest point at the start of the uptrend.

5. No indicator is perfect. Nobody will ever be able to design a perfect indicator. The best you can expect is that they give valuable signals much of the time.

6. Because indicators are not infallible, it is important to look for confirmation of signals from analysis of the price chart and perhaps from other indicators.

7. Because indicators are not infallible, always know the failure point and get out of your trade or investment quickly if the failure point is violated.

8. Indicators will never replace, or be a substitute for, analysis of the price chart. Indicators are not an easy way to avoid studying what price charts can reveal about the balance of supply and demand.