Bollinger Bands – A Great Trading Tool!
The bands reflect the price volatility in the last n-periods. The upper band corresponds to the sum of the simple moving average of the last n-periods and the standard deviation of price in the same n periods. The lower band corresponds to the subtraction of the simple moving average of the last n-periods and the standard deviation of price in the same n periods. The higher the volatility in the market the greater the standard deviation and hence the bands will be wider, and vice versa. When the band amplitude is less than that observed historically is a sign of the approaching of a significant movement in prices.
- An intermediate line that is a simple moving average (it can be an exponencial moving average) of N periods.
- A top line, at a height of K times the standard deviation of N periods over the middle line.
- A bottom line, which is at K times the standard deviation of N periods under the middle line.
Utility of Bollinger Bands
- It serves to locate the price within a range relative to its past performance.
- This indicator helps to determine whether or not the price is volatile.
- It allows to get price levels and determine whether the price is in areas of dynamics support or resistance.
Predictive Value of Bollinger Bands
Contrary to what is sometimes believed, Bollinger bands can not be used to make reliable predictions based on how close or far is the price of a instrument compared to its mean. This is because the market prices are not governed by any known distribution function (see stochastic process). For example, if the bands are calculated with a parameter of two times the standard deviation it can not be assumed that approximately 95% of the closing prices remain, on average, within the bands. This would require, among other things, that the prices have a normal distribution, which usually does not happen. Also, it would require knowing the true standard deviation. The standard deviation calculated in the formula is only an uncertain estimate of the true deviation. Additionally, it should be noted that the “standard deviation” of market prices for finite periods of time are not fixed parameters as required by the classical theory of statistics, but are variable and dependent on price volatility.
Despite all this, the bands have proven very useful in the analysis of market prices and according the Chebyshev inequality they contain at least 75% of the price. Bollinger bands offer a useful way to display the volatility of a market instrument. Also, the trader should not give a special meaning that the price touches the upper or lower band, as the same John Bollinger said. These events should be analyzed together with other factors before making investment decisions.
It is interesting to note that the false interpretation of touching or penetrating a price band, based on some wrong statistical assumptions, has become so popular that some investors now use these events as signals to initiate their positions and in doing so, inadvertently have given meaning to these events, which otherwise would not occur.
Interpretation of the Bollinger Bands
- The default values used for calculation is 21 for the moving average and 2 for standard deviations. If we reduce or significantly increase the moving average we have to adjust in the same way the number of standard deviations. To moving averages values above 50 (long term) => 2.5 deviations, moving averages near 10 (short term) => 1.5 deviations.
- If prices are above the moving average and close to the upper band and relatively high, this may indicate an overbought condition. If prices are below the moving average and near the lower band and relatively low, this may indicate an oversold condition in the market.
- If the bands are tightened on prices, this is an indication that the market in that period is not very volatile, however, if the bands are wide open that is a clear indication that the market is volatile. This provides an important aid to the investor that trades with options, for example.
- Usually, large and rapid movements in prices are produced after periods in which the bands are narrowed.
- Price movements that originate in one of the bands usually target the opposite side, which makes easy to determine price targets of these movements. Many of the extreme prices (maximum or minimum) of the movements, occur in or near the band.
- When prices exceed the upper band is a sign of strength of the instrument, on the contrary if the prices are below the lower band is a sign of weakness. When prices fall outside any of the bands is to assume the continuation of the movement.
- Used in conjunction with other indicators, the Bollinger Bands helps to find with high probability the resistances and supports in the markets.
- When the bands are close each other, this is a symptom of a period of low volatility in the market. When the bands remain far apart, this indicates a period of high volatility. When the indicator have only a slight slope and the bands remain roughly parallel for a time long enough, you will find that the instrument price fluctuates up and down between the bands, as in a channel. When this behavior is repeated regularly with a consolidating market, the investor can, with some confidence, using the touch (or almost) of the top or bottom band as a sign that the instrument price is approaching the limit of its trading range, and thus is likely to change its direction (at list at short term).