Bollinger Bands, Volatility And You

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Bollinger Bands, Volatility And You

Bollinger Bands, Volatility And You

Bollinger Bands ™ are one of the most dynamic and versatile trading tools on the market. The indicator was created by John Bollinger in the early 1980’s and captures one of his deepest insights. The idea that volatility was not static, that it changed from day to day, a thought contrary to popular market belief at the time. The tool presents as an envelope, similar to moving average envelopes, Keltner Channels and others but is based on measures of volatility. The bands are created from a standard deviation of price movement over a set period of time, much like basic volatility indicators such as historic and relative volatility. In my opinion, this is the best tool for measuring volatility but also a great tool for binary options traders to understand. It can be used in a wide variety of ways, gives of a number of easily recognizable signals and can be used as a stand alone indicator or with a package of other tools.

The tool is intended to show when prices are high or low relative to past price action. This means that prices are considered to be “high” when at the upper band and “low” when at the lower band. The indicator includes a total of three lines. The first is the central signal line, usually a simple moving average that is typically set to a period of 20. The same data used for the center line is then used to create the other two bands, the Bollinger Bands ™. These are a standard deviation of the central line, usually 2 but it, like the moving average itself, can be adjusted to your liking. Because the bands are based on a standard deviation of price movement they are highly sensitive to volatility in the market and change on a day to day basis as the mood of the market changes. The bands will expand when volatility is high and contract when volatility is low. Signals can be given when prices reach, cross or exceed any of the three bands or when the bands expand and contract, or a combination of the two. The thing to remember is that these signals are not tied to trend. The best use is as I have mentioned above, alongside other indicators, but here I will go over some of the basic signals that binary traders can use.

Simple And Profitable Bollinger Band Signals ™

The most signal is the simple expansion and contraction of the bands themselves. This represents increases and decreases in market volatility. When compared to price action and other indicators these swings can be powerful confirming indicators. For example, the bands have narrowed and the market trended in a tight sideways range and then the bands begin to widen. The widening of the bands means that volatility is beginning to creep into the market, suggesting a stronger move than “normal”. Your complimentary analysis tells you the market is about to sell off so you can assume that the move will be to the downside. Additionally, if the market has been trending and the bands are very wide, then begin to contract, you can assume that the trend is cooling off and then look for entries to suit.

You can also use the bands themselves to give signals. The rules for this vary from trader to trader and style to style, a sign of how adaptable the tool is. The following rules are more like suggestions and should be applied carefully when you first begin to use them with your strategy. The first is that when the bands widen following a period of contraction and price moves to touch either band it is often an indication of direction. There may be a pullback following the first touch but so long as prices do not overly exceed the bands they can be expected to continue in that direction into the near term.

Another signals occurs after the bands begin to widen and volatility has picked up. Basically, the bands provide limits where the market is considered to be highly priced. Usually, when prices exceed the band on either side it signifies that market has gotten ahead of itself and prices are extremely high or extremely low and about to pull back. This signal is good for really short term entries. This signal is incredibly accurate when used with Fibonacci Retracements or other support/resistance analysis.

A third signal useful for trades is the moving average cross. Price action can be expected to move from extreme to extreme regardless of the amount of volatility in the market. As prices trend higher, lower or sideways they will approach the center moving average and give signals. This could be a crossover which means that prices are likely to continue to the opposite band or they will be reversals, and prices will move back to the band they just left.

Look at the chart above. At point 1 price move from a period of low volatility to high volatility, indicating a move is on the way. They hit the upper band but exceed it, indicating the trend is up but that prices may pull back first. At point 2 prices have pulled back, to the center signal line, where they bounced in line with the original indication at point 1. At this time prices move higher again but at point 3 again exceed the band and indicate a pull back. The next pull back was mild, but tradeable, and lead to another trend following entry. Now, at point 4 prices are brushing the upper band but not exceeding it, indicating the trend is up and strong, but not overly priced with no indication of a pull back. When prices meet resistance it fails, as indicated by the Bollinger Bands ™.

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The Basics of Bollinger Bands®

In the 1980s, John Bollinger, a long-time technician of the markets, developed the technique of using a moving average with two trading bands above and below it.   Unlike a percentage calculation from a normal moving average, Bollinger Bands® simply add and subtract a standard deviation calculation.

Standard deviation is a mathematical formula that measures volatility, showing how the stock price can vary from its true value. By measuring price volatility, Bollinger Bands® adjust themselves to market conditions. This is what makes them so handy for traders; they can find almost all of the price data needed between the two bands.

Understanding a Bollinger Band®

Bollinger Bands® consist of a centerline and two price channels (bands) above and below it. The centerline is an exponential moving average; the price channels are the standard deviations of the stock being studied. The bands will expand and contract as the price action of an issue becomes volatile (expansion) or becomes bound into a tight trading pattern (contraction).

A stock may trade for long periods in a trend, albeit with some volatility from time to time. To better see the trend, traders use the moving average to filter the price action. This way, traders can gather important information about how the market is trading. For example, after a sharp rise or fall in the trend, the market may consolidate, trading in a narrow fashion and crisscrossing above and below the moving average. To better monitor this behavior, traders use the price channels, which encompass the trading activity around the trend.

We know that markets trade erratically on a daily basis even though they are still trading in an uptrend or downtrend. Technicians use moving averages with support and resistance lines to anticipate the price action of a stock.

Upper resistance and lower support lines are first drawn and then extrapolated to form channels within which the trader expects prices to be contained. Some traders draw straight lines connecting either tops or bottoms of prices to identify the upper or lower price extremes, respectively, and then add parallel lines to define the channel within which the prices should move. As long as prices do not move out of this channel, the trader can be reasonably confident that prices are moving as expected.

Bollinger Band® Definition

What Is a Bollinger Band®?

A Bollinger Band® is a technical analysis tool defined by a set of lines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of the security’s price, but can be adjusted to user preferences. Bollinger Bands® were developed and copyrighted by famous technical trader John Bollinger,

In the chart depicted below, Bollinger Bands® bracket the 20-day SMA of the stock with an upper and lower band along with the daily movements of the stock’s price. Because standard deviation is a measure of volatility, when the markets become more volatile the bands widen; during less volatile periods, the bands contract.

Key Takeaways

  • Bollinger Bands® are a technical analysis tool developed by John Bollinger.
  • There are three lines that compose Bollinger Bands: A simple moving average (middle band) and an upper and lower band.
  • The upper and lower bands are typically 2 standard deviations +/- from a 20-day simple moving average, but can be modified.

Understanding Bollinger Bands

How To Calculate Bollinger Bands®

The first step in calculating Bollinger Bands® is to compute the simple moving average of the security in question, typically using a 20-day SMA. A 20-day moving average would average out the closing prices for the first 20 days as the first data point. The next data point would drop the earliest price, add the price on day 21 and take the average, and so on. Next, the standard deviation of the security’s price will be obtained. Standard deviation is a mathematical measurement of average variance and features prominently in statistics, economics, accounting and finance. For a given data set, the standard deviation measures how spread out numbers are from an average value. Standard deviation can be calculated by taking the square root of the variance, which itself is the average of the squared differences of the mean. Next, multiply that standard deviation value by two and both add and subtract that amount from each point along the SMA. Those produce the upper and lower bands.

Here is this Bollinger Band® formula:

What Do Bollinger Bands® Tell You?

Bollinger Bands® are a highly popular technique. Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. John Bollinger has a set of 22 rules to follow when using the bands as a trading system.

The Squeeze

The squeeze is the central concept of Bollinger Bands®. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities. Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or which direction price could move.

Breakouts

Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event. The breakout is not a trading signal. The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.

Limitations of Bollinger Bands®

Bollinger Bands® are not a standalone trading system. They are simply one indicator designed to provide traders with information regarding price volatility. John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals. He believes it is crucial to use indicators based on different types of data. Some of his favored technical techniques are moving average divergence/convergence (MACD), on-balance volume and relative strength index (RSI).

Because they are computed from a simple moving average, they weight older price data the same as the most recent, meaning that new information may be diluted by outdated data. Also, the use of 20-day SMA and 2 standard deviations is a bit arbitrary and may not work for everyone in every situation. Traders should adjust their SMA and standard deviation assumptions accordingly and monitor them.

The bottom line is that Bollinger Bands® are designed to discover opportunities that give investors a higher probability of success.

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