Introducing Bollinger Bands

 

 

MoneyVidya.com Investor Essentials: Introducing Bollinger Band Indicators: Bandwidth and %b

Tuesday, 07 April 2009   

 

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  Introducing Bollinger Bands The use of trading bands or price envelopes has a long history and can be traced back to J. Hurst’s The Profit Magic of Stock Transaction Timing; in which he manually drew smoothed envelopes to aid in cycle identification. In the 1970s, shifted moving averages were increasingly used to identify trend changes and then Bomar Bands, which are constructed in order to contain a fixed percentage of the data, became popular.

Bollinger Bands were developed by John Bollinger in the 1980s and unlike other price envelopes use volatility to determine the position of the upper and lower bands. Bolinger Bands use a simple moving average of price as the centre line. The upper and lower bands are calculated by adding and subtracting a multiple of the standard deviation of the data. In essence, moving standard deviations are used to create price bands around a moving average. The standard Bollinger Band uses 2 standard deviations, an example is shown below.

Bollinger Bands can be used in relation to any length of cycle, using different period moving averages, however the most commonly used is the 20-day period. When using a different period moving average, Bollinger recommended flexing the number of standard deviations used. For example it is common to use 2.1 standard deviations for a 50 period moving average while using 1.9 standard deviations at 10 periods.

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  Indicators Derived from Bollinger Bands There are two commonly used secondary indicators which can be derived from Bollinger Bands, %b and BandWidth. %b measures where within the bands the observed price sits; 100% indicates the current price is touching the upper band upper band, 0% the lower band. % Tagging the bottom band (%b=0) is an indication that current price is unusually low, and is generally thought to be a bullish signal. Similarly the tagging of the upper band (%b=100) is an indication that the current price is unusually high and is generally thought to be a bearish signal. Band width, another indicator derived from Bollinger Bands, measures the width of the bands as a percent of the moving average;

A low bandwidth implies that volatility of prices has been low in recent periods and therefore that prices have been trading in a tight range. A small or declining bandwidth can be an indicator of an upcoming breakout in price if the temporary equilibirum between buyers and sellers fails to hold. As Bollinger Bands are a common in modern charting packages, visual observation of narrowing bands can serve as well as measuring the Bandwidth, similarly one can easily see how close to the upper or lower bands the current price is without calculating %b.

Using Bollinger Bands to derive trading signals Although tagging the bottom band is an indication that current price is unusually low, this should not in itself generate a buy signal unless the bullish sentiment is confirmed by another indicator, similarly the tagging of the upper band does not in itself constitute a sell signal unless confirmed. The choice of confirming indicator is important and as the Bollinger Bands are a function of price, care should be taken when using a price indicator to confirm, RSI or MACD are among the best choices. Appropriate confirming indicators can also be derived from momentum, volume, sentiment or a combination of price and volume such as on-balance volume (OBV) or Chaikins Money Flow.

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