Trading Basics—Bollinger Bands and Bandwidth

06/05/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Several articles ago, we discussed the STARC bands, developed by Manning Stoller, and in this article, I would like to introduce another banding technique, made popular by John Bollinger, called Bollinger Bands. Though they have some similarities with the STARC bands, there are also some significant differences.

Both bands came into existence in part due to frustration with percentage bands in the early 1980s. These bands were plotted at a set percentage around a fixed moving average. The problem was that they would not adapt to changes in market behavior or volatility. Therefore, prices might stay within the bands for months or even years, but when the stock’s (or market’s) volatility increased, prices would move outside the bands and could stay there for long periods of time, because this change could not be addressed. This made them virtually worthless as a way to determine extreme highs or lows. Both the STARC and Bollinger bands were created to address this issue.

The Bollinger Bands use a simple moving average, generally a 20-period, and then, the upper band (green line) is plotted by adding two standard deviations (using the moving average calculation) to the moving average (red line) while the lower band (blue line) is calculated by subtracting two standard deviations from the moving average.

As was the case with STARC bands, Bollinger Bands have many different applications by individual traders. Some use them as a type of trading system where violations of the moving average signal a move to the upper or lower band. Closes outside of the bands are viewed by many as a type of continuation signals that are similar to those generated by volatility breakout systems. John Bollinger has his own set of rules and guidelines, which can be found on his Web site at www.bollingerbands.com.

Figure 1
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From recent articles, I am sure many of my readers are aware of the recent rally in the Japanese stock market, and the NK225 provides an excellent example of how the Bollinger Bands work. The weekly chart of the NK225 features the upper Bollinger band (green), 20-period moving average (red) and the lower Bollinger band (blue). I have also added another indicator at the bottom of the chart, which is a plot of the bandwidth (BW) or the difference between the upper and lower bands. At the beginning of the chart in September of 2002 the NK225 was declining and the gap between the bands peaked at 3500 points (line A). Gradually, the bands moved closer together and by February of 2003 the BW had dropped to a low of 600 (line B). The bands did begin to widen again over the next few months, and then in June expanded rapidly as the NK225 rallied sharply and closed above its upper band (see arrow). The bands continued to widen until September (line C) when the BW peaked at 3352. It should be clear that when prices trade in a narrow range and volatility is low, the bands move closer together. Conversely, when prices rise or fall sharply, the bands expand and therefore the volatility increases. Thus peaks and valleys in the BW can be used to measure the extremes in volatility. This can provide some important information for traders, as some methods do well in periods where volatility is high, while others work best when volatility is low.

From September 2003 through early 2005, the BW declined (line 1) and reached a low of 495 in December 2004 (line D). At this point the bands were quite close together, as the dashed circle indicates. This narrowness made an increase in volatility quite likely. The BW rose gradually to the 1300 level, and then stayed flat until early August before surging to a new high for the past year. The sharp rally in the BW that continued in September clearly signaled a change in market dynamics. In late December of 2005 the weekly BW had risen to over 4500.

Figure 2
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The daily chart of the NK225 gives a much different picture as Fig. 2 covers the past year. From February through mid-April the BW did not go above 600 (line A) with a low point of 257. This range was then exceeded (point 1) for about two weeks, peaking at 1402 (line B). The bandwidth quickly contracted and stayed low from mid-May through early August (line C), even though the NK225 started to edge higher during the summer. The start of the recent strong rally in the NK225 coincided with the BW breaking out of its previous trading range (point 2). As the NK225 moved from 11,614 in early August to 16,111 at the end of December, the BW has made a series of higher highs, points 3 and 4, confirming the price action. This is characteristic of a market that is trending, and in this case trending higher. A significant change in the weekly and the daily BW would be expected before a significant correction gets underway. The weekly BW currently stands at 4900 with a high since 1997 of 6004.

So how can one best incorporate the Bollinger Bands into one’s trading system? There are several ways that I find them useful, and I use them much differently than the STARC bands. Bollinger Bands are most useful in helping to identify periods of low volatility, which often occur at significant turning points. Low volatility correlates with narrow trading ranges, which allows for tight stops to be used on either long or short positions. Of course, the direction of the breakout needs to be determined, and to do this I would favor using at least one volume and one momentum indicator.

In order to monitor the volatility, it is important to have as much data available as possible on the market you are trading. As I have mentioned previously, trading based on a short data series can be hazardous to your financial health. It could be compared to taking a road trip with only half a map. If you take the time to analyze your losing trades of the past year, you may find that going further back in that market’s history would have altered your trading strategy.

Figure 3
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The long-term weekly chart of crude oil goes back to early 2000, and provides a good, long-term picture not only of the price history, but also of the BW. Two horizontal reference lines are shown on the chart of the BW. As a measure of high volatility, line A is drawn at $16. This means that over the past five years when the upper and lower Bollinger Bands are $16 a part, the volatility is high. Similarly, line B is drawn at the $5 level, so when the bands are only $5 or less apart, volatility is low. Starting in June 2001 (point 1) the BW dropped below $5 and stayed at this level for about three months. As the BW expanded in late September, crude oil dropped from a high of close to $30 to under $17 per barrel. The following peak in the BW was at just over $14 per barrel. Once again in July 2002, the bands narrowed, dropping the BW to a low of $4.40 (point 2). The BW stayed below $7 until November and crude dropped to the lower Bollinger Band for two weeks. By late December the BW had moved above $7 and crude was soon pushing above the upper bands (line C). The BW was above $16 in February indicating a high level of volatility and of risk. Traders who were long could (and should) have used this information to take some profits, or to at least use tighter stops.

The most recent low point in the BW occurred in September 2003 when it dropped below $6. Once again this low point coincided with crude dropping to the lower Bollinger Band, before beginning the recent rally that has taken the nearby contract to over $70 per barrel. So far the peak in the BW (line D) has been just over $21. This peak in the BW coincided with several weeks of trading at the upper Bollinger Bands. At the start of 2006, crude prices are once again moving higher with the BW currently at $13.50, indicating a relatively high level of volatility.

Being able to identify periods of high volatility is another way that I find the Bollinger Bands and the BW to be quite useful. If high points in the BW are identified, it can alert the trader to an increase in risk, which should lead to a modification of their trading strategy. That does not mean one should not trade markets with historically high BW readings but moreover that this information should be factored in when determining their entry/exit points and the protective stops that are used. In the next article, I will show how these bands can be useful for option traders, and I will also give a comparison of the STARC and Bollinger Bands.

.As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow's MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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