What are Bollinger bands? Bollinger bands (B bands) as developed by John Bollinger are volatility bands that are positioned above and below of a moving average. Standard deviation is the basis upon which volatility is built and it changes with increasing or decreasing volatility. In other words, standard deviation is directly proportional to volatility. The band automatically widens as volatility increases. Due to the dynamic nature of Bollinger bands, they can be applied on different securities with the standard settings. For example, it can be used to identify M-tops and W-Bottoms or to determine the strength of the trend.
Bollinger band trading.
Bands are made up of a middle band which has two outer bands. The middle band refers to a simple moving average that is mostly set at 20 periods. The reason for using a simple moving average is because the standard deviation formula also uses a simple moving average. You must also know that the look-back period for the simple moving average is the same as that of the standard deviation. Usually, the outer two bands are set to two standard deviations below and above the middle band.
You can make some adjustments to fit the properties of a particular security or trading style. B. bands require that small incremental adjustments be made to the multiplier of standard deviation. The number of periods that are used to calculate the standard deviation gets affected when the number of periods for the moving average gets changed. Ego only small adjustments are needed for the multiplier of standard deviation. An increase in the period for the moving average will automatically trigger an increase in the number of periods for the standard deviation calculation which will also cause an elevation in the multiplier for the standard deviation. For a 20-day SMA and 20-day standard deviation, the multiplier for standard deviation is set at 2. B band suggests that for a 50-period SMA, the multiplier for standard deviation should be increased to 2.1 and for a 10-period SMA, decrease the standard deviation multiplier to 1.9
Arthur Merrill the originator of W-Bottoms, was able to identify 16 patterns from a basic W shape. Bollinger makes use of the various W patterns with B. bands in order to identify W-Bottoms. W-Bottoms is formed when there is a downtrend and it also involves tow reaction lows. Typically, Bollinger searches for W-Bottoms where the second low is lower than the prior but holds above the lower band. There are four basic steps to consider in other to confirm a W-Bottom with B bands. A reaction low is firstly formed. This reaction low is mostly below the lower band but it is not always the case. Secondly, a bounce occurs towards the middle band. Thirdly there must be a new price low in the financial instrument. This low is able to hold above the lower band. Lastly, you confirm the pattern with a strong move off the second low and a resistance break.
The chart below (Chart 2) illustrates a typical example of how to identify W=Bottoms. It illustrates Nordstrom (JWW) having a W-Bottom in 2010 between January -February. The stock firstly formed a reaction low in the month of January and it broke below the lower band. Secondly, a bounce back occurred above the middle band. Thirdly, the stock price moved below its previous January low and held above the lower band. Despite the fact that the February 5th spike low broke the lower band, when calculating Bollinger bands we used the closing prices as such the signals should also be based on the closing price. Fourthly, the stock elevated strongly with expanding volume in the latter days in February and broke above the high of early February. The chart below (chart 3) illustrates Sandisk having a smaller W-Bottom in 2009 between the months of July and August.
Just like the W-Bottoms, M-Tops was also founded by Arthur Merrills, where he was able to identify 16 patterns with a basic M shape. The M pattern together with the Bollinger Bands are used to identify M-Tops. Tops are mostly complicated and easily drawn out that bottoms, according to Bollinger. Evolving tops include head-and-shoulders patterns, double tops, and diamonds.
M-Top is similar to a double top in the most fundamental form but the reaction highs are not always equal. It is possible for the former high to be higher o lower than the second high. You should look for non-confirmation signs especially when a security is making new highs as suggested by Bollinger. In basic terms, this is opposite to W-Bottom. There are three steps to consider when looking for non-confirmational signs. Firstly, a reaction high is created by a security above the upper band. A pullback towards the middle band occurs as the second step. The third step to consider is the price movement which should be above the former higher but fail to reach the upper band. This is considered as a warning sign. The significant inability of the second hight to be able reach the upper band signifies a warning momentum which has the potential to foreshadow a trend reversal. A support break or bearish indicator signal is the symbol for a final confirmation.
This chart is a representation of Exxon Mobile (XOM) with an M-Top between the months of April and May in the year 2008. The stock surpassed the upper band in the month of April. A pullback occurred in May as well as another push above 90. Despite the fact that the stock surpassed the upper band on an intraday basis, it could not close above the upper band. The confirmation for M-Top was a support break which occurred two weeks later.
This is chart a chart of a representation of Pulte Homes (PHM) in an uptrend between the months of July and August in the year 20018. The price surpassed the upper band in the beginnings of September to affirm the uptrend. The stock moved to a higher high above 17 after a pullback that was below the 20-day SMA (middle Bollinger Band). The price refused to surpass the upper band despite the new high of a move. This also serves as a warning sign. After a weeks time, MACD moved below its signal line and the stock broke support.
Walking The Bands.
Suffice to say movements above and below the bands are not considered to be signals per say. As stated by Bollinger, movements that touch or surpass the bands are not signals, rather tags. Movement to the top band signifies strength whilst movements to the lower bands signify weakness. Momentum oscillators work in a similar fashion. Overbought does not necessarily signify bullish movement. It requires significant strength to reach overbought levels and the conditions attached to overbought can extend in a strong uptrend. In a similar fashion, prices are capable of “walking the band” with countless touches during the period of a strong uptrend. Since the upper band is set to 2 standard deviations above the 20-period simple moving average, it will require a price move of significant strength to be able to surpass this upper band. Whenever an upper band touch happens after a Bollinger Band has confirmed W-Bottom, it signifies the beginning of an upward trend. Just as it is possible for a strong upward trend to produce countless upper band tags, it is also a very common occurrence for prices to never get to the lower band during the period of an upward trend. Sometimes the 20-day SMA also acts as support. In reality, dips below the 20-day SMA provides opportunities for buying but on rare occasions before the next tag of upper band.
This chart (chart 6) is a representation of air product (APD) with a close and surge above the upper band in the middle of the month of July. On closer inspection, you realize that this is a strong surge that broke above two levels of resistance. Whenever you see a strong upward movement it signifies strength and not weakness. The 20-day SMA moved significantly sideways and trading also became flat in the month of August. Also, the Bollinger bands became thin but APD refused to close below the lower band. Eventually the 20- day SMA, as well as prices, started moving up in the month of September.
From everything mentioned above, it is true to state that Bollinger bands can also be used to determine the relative high or low of prices. This is due to the fact that Bollinger Bands are able to reflect direction with the 20-period SMA and volatility with the upper or lower bands. As stated by Bollinger himself, bands must contain 88-89% of the price movement. You should always bear in mind that Bollinger Bands are not supposed to be used as independently. Technical analyst should aggregate Bollinger Bands with basic trend analysis as well as other indicators for complete confirmation.