Bollinger Bands

Bollinger Bands were created by John Bollinger and are quite effective at determining how far a stock will move away from an underlying trend.

Bollinger Bands are similar to moving average envelopes in that they envelop the share price. The distance away from the share price is set by standard deviation therefore the volatility is taken into consideration. The more volatile the stock, the further away the bands and vice versa. Suffice to say that the bands widen and contract depending on the volatility of the share.

John Bollinger made the following notes of the characteristics of Bollinger Bands:

• Sharp price changes tend to occur after the bands tighten, as volatility lessens.
• When prices move outside the bands, a continuation of the current trend is implied.
• Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
• A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.

You will note in the chart at the bottom, that the central thicker line is the 20 period moving average upon which the outer bands are based. The two bands are known as the upper and lower bands and you can see how their distance from the central moving average varies along the chart.

You will notice that towards the end of the chart, there are some wider trading ranges which directly impact the volatility. Consequently, the two bands widen to accommodate the increased volatility.

A simple interpretation of the Bollinger Bands is to buy when the security breaks below the lowest band and then crosses back above it. Often the lowest band is the extreme of the security’s downward movement. This is similar for the upper band. When the security travels above the upper band and crosses back down below, this would produce a short signal.

Bollinger recommends using "20" for the number of periods in the moving average, calculating the moving average using the "simple" method, and using 2 standard deviations. He has also found that moving averages of less then 10 periods do not work very well.