Bollinger Bands (a technical and statistical tool) created by John Bollinger, are a great technical analysis overlay that are used to determine the future direction of a financial asset. Briefly, a Bollinger Band is a product that displays a specific moving average along with a channel of two bands that are a variable standard deviation above or below the moving average. Bollinger Bands are very helpful in that they can assist with calculating breakouts; trends, mean reversion and risk management (stop losses and take profits). The chart displays a 20-day moving average of the EUR/USD along with the associated Bollinger Bands.
A moving average is the average of a specific number of price points, divided by the number of price points, which creates the average. An average is moving, when the price point outside the specific number is dropped from the total average. For example, for a 20-day moving average, on the 21st day, the first price is dropped from the calculation of the moving average. This process continues, so on the 22nd day, the 1st and the 2nd price points are dropped from the 20-day moving average.
A standard deviation is a calculation, which determines how spreads out a range of number are from one another. The calculation also determines how close groups of numbers are to the mean (the average). For a normal distribution, the majority of the data, which is approximately 68% of the data, will fall within plus or minus one standard deviation of the statistical average. This means that if the standard deviation of a data set is two, the majority of data in the set will fall within two standard deviations of the mean. Approximately y 95.5% of normally distributed data is within two standard deviations of the mean, and over 99% are within three standard deviations of the mean.
How to Use Bollinger Bands:
Bollinger Bands are a group of technical tools that help traders and investors create strategies to determine the future direction of the market. There are a number of standard techniques that traders use to initiate trades using Bollinger Bands. There are also a number of specific non-conventional strategies that can assist investors in creating excellent trades.
The most common way to use Bollinger Bands is to employ the technical tool for mean reversion analysis. The idea behind mean reversion is that a financial instrument will only trade a finite distance away from its mean before it snaps back. The idea is to take advantage of the concept metaphorically that a rubber band can only stretch so far. Additionally, the most common setting for the Bollinger Bands is a 20-day moving average, and two standard deviations. This setting will show prices for a financial asset, the 20-day moving average of the financial asset, and a depiction of where 95% of the trades should fall over the 20-day period. By using this calculation, an investor will capture the majority of the trades that fall within a normal bell curve.
The upper and lower ranges of the Bollinger Bands, which are created by the 2-standard deviation lines, create the boundaries that encompass the mean reversion strategy. When a financial asset moves above the upper boundary, a trader will sell short, with the expectation that the market will revert to the 20-day moving average. When the market moves below the lower boundary of the Bollinger Bands, a trader will buy, with the expectation that the markets will move upward back to the 20-day moving average.
Besides acting as an excellent mean reversion tool, Bollinger Bands work extremely well as a technical tool that can alert a trader that a breakout or trend is about to occur. Most investors use the Bollinger Bands specifically as a way to measure mean reversion, but do not examine the dynamics of the outside bands to assist in the process of determining markets movements.
The actual direction of the bands can play a large role in determining direction, because they show a trader either dispersion or contraction in price action. As Bollinger bands move in opposite directions, there are specific changes occurring in price action, which are making the standard deviation range widen. When this occurs, volatility is beginning to pick up, and volume is starting to increase.
When the market is beginning to trend or break out, and prices of a financial instrument moves from the lower Bollinger Band, through the moving average and above the higher Bollinger Band, while at the same time the Bollinger Bands are widening from one another, a very bullish signal is being created. As the market moves higher on higher volatility and potential volume and the standard deviations of the prices are moving, larger movements in price action will occur to the upside. The converse is also true. When prices move from a higher Bollinger band through the moving average and down through the lower Bollinger Band, while the Bollinger Banks are widening, a very bearish signal is being created. Higher volatility created by larger standard deviations as prices move lower will create potential gas and large swings to the downside.
When using Bollinger Bands in this type of scenario, it is important to realize that a breakout is occurring and a trader should look at buying or shorting the breakout or trend. Another key element is to avoid using Bollinger Bands as a mean reverting instrument when the market is displaying trending tendencies. In this situation, not only are Bollinger Bands action as a technical entry tool, but it is also acting as a risk management tool, in avoiding trades that are likely to fail.
Bollinger Bands have many facets and one of them is their ability to track and monitor historical volatility. Volatility within a financial market is a measure of the standard deviation of the instrument annualized over a period. The distance between the upper Bollinger Band and the Lower Bollinger Band is a simple measure of volatility.
Bandwidth, (which is the distance between the upper and lower Bollinger Bands), is a Non-normalized measure of the distance, or difference, between the upper band and the lower band. Bandwidth decreases as Bollinger Bands narrow and increases as Bollinger Bands widen. Because Bollinger Bands are based on the standard deviation, falling Bandwidth reflects decreasing volatility and rising Bandwidth reflects increasing volatility.
Defining the width of the bands can be accomplished in numerous ways. It is important to remember that Bandwidth varies according to security’s volatility and price. For reference, normalized Bandwidth divides the difference in Bollinger Bands by the middle band. Additionally, A Bandwidth value needs to be calculated relative to a historical norm, or relative to the underlying value of the financial instrument. For example, a band width of 10 would be considered narrow for $200 a stock, but wide for a $30 stock. Five is 5% of 200, is relatively narrow. Usually, a bandwidth is considered low (narrow) when it is 5-10% of a security’s price. Low Bandwidth for a $50 stock would range from 2.5 to 5, while low Bandwidth for a $20 stock would range from .50 to 1. Depending on underlying volatility, the definition of narrowness may vary from stocks to stock.
Narrow Bandwidth can also be gauged relative to prior Bandwidth values over a period. It is important to get a good look-back period to define Bandwidth range. For example, a one-year chart will show Bandwidth highs and lows over a significant timeframe. Bandwidth is considered narrow as it approaches it the lows of its one-year range and high as it approaches the highs of its range.
When Bandwidth is low and therefore volatility is low, the market is set to move quickly and will probably mean revert. When Bandwidth is high, the markets will probably trend or continue on a particular path.