Introduced in 1983, ‘Bollinger Bands’ is a popular volatility indicator that can help traders confirm price trends and identify volatility squeezes. The following article is based on the book “Bollinger on Bollinger Bands” by John Bollinger.
Key Points
- Bollinger Bands is capable of defining high and low in the market
- Volatility is the key, as the two bands are constructed above and below a measure of central tendency
- There are 3 different methods to trade with Bollinger Bands
- Two indicators directly derive from Bollinger Bands, %b, and BandWidth
- BandWidth was created to measure ‘The Squeeze' pattern
- Bollinger Bars can help in pattern recognition by clarifying patterns such as M-tops, W-bottoms, momentum shifts, etc.
- Pattern recognition is the process of recognizing recurring events with discrete parts combined in a specific sequence
- Two key seasonal patterns in the U.S. stock market include an annual and a 4-year pattern
- Bollinger Bands can be combined with TA indicators from many different categories as long as they are not collinear
- The multicollinearity can be avoided by using only one indicator from each category
- Combining volume and sentiment indicators works well in a diversification strategy (avoiding multicollinearity risks)
- A major misconception when trading with the Bollinger Bands is that you should buy at the lower band and sell at the upper band
- When the price closes outside the Bollinger Bands it should be considered a continuation signal, not a reversal signal
- Bollinger Bands signals derive from interactions with the bands, not from crossovers
Before moving forward, let’s refer to the main types of investment analysis.
Technical, Fundamental, and Rational Analysis
Technical analysis assumes that information is already incorporated in the price structure, and therefore, takes for granted that the price structure itself is the best source of information. On the other hand, fundamental analysis estimates the economic value of a financial entity by comparing this value with the market price.
- Technical analysis is the study of market-related data while fundamental analysis is the study of economic-related data
- In essence, technical analysis believes that the market is right while fundamental analysis that the analysis is right
- Rational analysis is the combination of technical and fundamental analysis
Introduction to the Bollinger Bands
The two Bollinger Bands are constructed above and below a measure of central tendency.
- Envelopes are constructed around the price structure and calculated by shifted moving averages, above a moving average of the highs and below a moving average of the lows
Standard Bollinger Band Formulas
- Middle band = 20-period moving average
- Upper band = Middle band + 2 standard deviations
- Lower band = Middle band - 2 standard deviations
The data for the volatility calculation is the same data that was used for the moving average.
Timeframes and Bollinger Bands
Typical settings include a Daily bar chart, a 20-day calculation period, and 2 standard deviation bands. Bollinger Bands can be used in all timeframes (short-term, intermediate-term, and long-term):
- Short-term is the timeframe for executing trades. Important data comes from TA indicators, price patterns, volatility, etc.
- Intermediate-term is the timeframe for analyzing the market. Broad market statistics can be important here
- Long-term is the time frame for investors with long horizons, important factors might be the direction of the 200-day average or the slope of the yield curve
Table: Possible Time-Frame Combinations
SHORT-TERM |
INTERMEDIATE-TERM |
LONG-TERM |
WEEK |
QUARTER |
YEAR |
WEEK |
MONTH |
QUARTER |
DAY |
WEEK |
MONTH |
HOUR |
DAY |
WEEK |
10-MINUTES |
HOUR |
DAY |
TICKS |
10-MINUTES |
HOUR |
Bollinger Bands Signals
Bollinger Bands signals derive from interactions with the bands, not from crossovers.
- Identify the correct average by looking for the average that provides support to reactions, especially the first reaction after a change in trend
- For example, if the market rallies for 8 days, and then pulls back for 4 days before turning higher again, the correct average should have offered support at the low of the 4-day pullback
Two Indicators Directly Deriving from Bollinger Bands
Two indicators directly derive from Bollinger Bands, %b, and BandWidth.
%b
- %b = ( Last - lower BB ) / ( Upper BB - Lower BB )
- %b tells us where we are in relation to the Bollinger Bands
- %b aids traders in pattern recognition
- %b is the key to the development of a trading system
BandWidth
- BandWidth = ( Upper BB - Lower BB ) / Middle BB
- BandWidth identifies how wide the Bolinger Bands are, and helps traders recognize “The Squeeze”
- “The Squeeze” refers to a situation where volatility has fallen so much that this lowness becomes a forecast of increased volatility. The simplest approach to this is to note when BandWidth is at a six-month low
- BandWidth also marks the end of strong trends, often born in “The Squeeze”
Image: %b and BandWidth on S&P500
Three (3) Methods for Using Bollinger Bands
There are three different methods for trading with Bollinger Bands. These methods are focused on the daily chart as their primary timeframe, however, short-term traders may use them even on the five-minute bar chart.
■ Short-term traders → five-minute bar chart
■ Swing traders → daily chart
■ Investors → weekly chart
The greatest misconception when trading with the Bollinger Bands is that you should buy at the lower band and sell at the upper band. They can work that way, but they don’t have to.
Method 1 -The Squeeze
- Method 1 is also known as “The Squeeze” and is entirely focused on volatility
- Taking advantage of the cyclical nature of volatility and anticipating that extremely low volatility is a precursor of high volatility
Buying & Selling
□ Buying when the upper band is exceeded
□ Selling when the lower band is broken to the downside
Method 2 -Combining BB with Other Indicators
- Combining BB with another indicator
- Method 2 buys market strength and sells market weakness
- Buying on strength as the price approaches the upper band nut only if an indicator confirms it
- Selling on weakness as the lower band is approached, again only if confirmed by our indicator
Buying & Selling
□ Buying when %b is greater than 0.8 and MFI is greater than 2O
□ Selling when %b is less than 0.2 and MFI is less than 20
Method 3 -Combining BB with Other Indicators
- Buying near the lower band, using a W pattern and an indicator to clarify the setup
- Selling near the upper band on a series of tags accompanied by a weakening indicator
- Using MACD to calculate the breadth indicators
Buying & Selling
□ Buying setup: lower band tag and the oscillator positive
□ Selling setup: upper band tag and oscillator negative
Bollinger Bands and Pattern Recognition
Pattern recognition is the process of recognizing recurring events with discrete parts combined in a specific sequence. Bollinger Bands can provide the necessary framework within which these patterns can be clarified and successfully identified.
- Patterns may be included in fractals (patterns evolving in multiple timeframes simultaneously)
- The most common patterns are the Ms (tops) and Ws (bottoms)
- Lows (highs) outside the bands followed by lows (highs) inside the bands are typically considered reversal patterns
- As the patterns evolve, the Bollinger Bands evolve along with them
- Volume and momentum indicators can confirm tops and bottoms
Bollinger Bands can be useful in pattern recognition by showing:
- high and low
- volatile or calm
- trending or not-trending
W Patterns (Bottoms)
- Buying the strength of the market, after the completion of a W pattern
- W bottoms are common patterns (spike bottoms are rare)
- Ws may be transitions to bases rather than reversals
Arthur Merrill's W Patterns and Timeframes
- Uptrends: M15, M16, W14, W16
- Downtrends: M1, M3, W1, W2
- Head and shoulders: W6, W7, W9, W11, W13, W15
- Inverted head and shoulders: M2, M4, M6, M8, M10, M11
- Triangle: M13, W4
- Broadening: M5, W12
M Patterns (Tops)
- Selling the market after a sign of weakness by waiting for countertrend rallies
- Tops are more complex and harder to diagnose than bottoms
- The best-known top pattern is the H&S (head-and-shoulders)
- Three pushes to a high is a common formation
The Squeeze Pattern
The Squeeze pattern is a pure reflection of Bollinger Band's volatility.
- BandWidth was created to measure ‘The Squeeze'
- The 'Squeeze' is triggered when the BandWidth is found at its lowest level in 6 months
- Commonly, as the 'Squeeze' is near completion, the price makes a short fake-out move and then surges in the direction of the dominant trend
Combining BB with other Indicators -Avoiding Collinearity
Bollinger Bands can be combined with TA indicators from many different categories. The problem is that many TA indicators are collinear, meaning that two or more indicators contain similar information and end up being highly correlated.
- Combining volume and sentiment indicators works well in a diversification strategy (avoiding multicollinearity risks)
- Momentum and trend indicators are less useful than volume or sentiment indicators
Image: Bollinger Bands and RSI Precision in Ethereum
The multicollinearity can be avoided by using only one indicator from each category. General categories include the following:
Category |
Indicators |
|
Rate of change, stochastics |
|
Linear regression, MACD |
|
Survey, Put-Call Ratio |
|
Intraday Intensity, Accumulation Distribution |
|
Money Flow Index, Volume-Weighted MACD |
|
Commodity Channel Index, RSI |
As concerns volume indicators, this is how they should be used.
Volume Indicators
Volume Indicators |
|
|
On Balance Volume, Volume-Price Trend |
|
Negative and Positive Volume Indices |
|
Intraday Intensity, Accumulation Distribution |
|
Money Flow Index, Volume-Weighted MACD |
More about volume indicators on CarryTrader: https://carrytrader.com/learning/technical-analysis/67-volume-analysis
Basic Rules When Using the Bollinger Bands
- Bollinger Bands provides a relative definition of high and low. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band
- When the price closes outside the Bollinger Bands it should be considered a continuation signal, not a reversal signal
- Bollinger Bands already incorporate trend and volatility, therefore, their use for confirmation of the price action is not recommended
- Bollinger Bands can be combined with multiple indicators of different categories (Using indicators from the same category creates collinearity)
- Tags of the bands are just tags, not signals
■ Trading with the Bollinger Bands
G.P. for CarryTrader.com (c) November 28th, 2024
Source: The Book “Bollinger on Bollinger Bands” by John Bollinger
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