The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions.
When using Bollinger Bands it is easy to see that they consist of a set of three curves drawn in relation to securities prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, which serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes.
Tips for Using Bollinger Bands (Rules)
John Bollinger states that “One of the great joys of having invented an analytical technique such as Bollinger Bands is seeing what other people do with it.
There are many ways investors are using Bollinger Bands, but it is important to follow a few rules that will serve as a good beginning point.”
1. Bollinger Bands provide a relative definition of high and low.
2. That relative definition can be used to compare price action and indicator to arrive at rigorous buy and sell decisions.
3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc.
4. Volatility and trend have already been deployed in the construction of Bollinger Bands, so their use for confirmation of price action is not recommended.
5. The indicators used for confirmation should not be directly related to one another. Two indicators from the same category do not increase confirmation. Avoid co linearity.
6. Bollinger Bands can also be used to clarify pure price patterns such as M-type; tops and W-type bottoms, momentum shifts, etc.
7. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.
8. Closes outside the Bollinger Bands can be continuation signals, not reversal signals--as is demonstrated by the use of Bollinger Bands in some very successful volatility-breakout systems.
9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the bandwidth are just that, defaults. The actual parameters needed for any given market/task may be different.
10. The average deployed should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.
11. If the average is lengthened the number of standard deviations needs to be increased simultaneously; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced;
from 2 at 20 periods, to 1.9 at 10 periods.
12. Bollinger Bands are based upon a simple moving average. This is because a simple moving average is used in the standard deviation calculation and we wish to be logically consistent.
13. Be careful about making statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The sample size in most deployments of Bollinger Bands is too small for statistical significance and the distributions involved are rarely normal.
14. Indicators can be normalized with %b, eliminating fixed thresholds in the process.
15. Finally, tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.
Effectiveness of using Bollinger Bands
A recent study concluded that using Bollinger Bands trading strategies may be effective in the Chinese marketplace, stating: "Finally, we find significant positive returns on buy trades generated by the contrarian version of the moving average crossover rule, the channel breakout rule, and the Bollinger band trading rule, after accounting for transaction costs of 0.50 percent."
Picture: Chinese Marketplace
Nauzer J. Balsara, Gary Chen and Lin Zheng The Chinese Stock Market: An Examination of the Random Walk Model and Technical Trading Rules. (By "the contrarian version", they mean buying when the conventional rule mandates selling, and vice versa.) A paper by Rostan, Pierre, Théoret, Raymond and El moussadek, Abdeljalil from 2008 at SSRN uses Bollinger Bands in forecasting the yield curve.
In his 2006 master's thesis, Oliver Douglas Williams at the University of Western Ontario studied investors using Bollinger Bands and suggested that fundamental analysis was key to setting Bollinger Band parameters, a process John Bollinger dubbed rational analysis. Williams concluded: "Alone, Bollinger Bands do not seem to yield the extraordinary results. Fundamental analysis is required to determine the best moving average window to match the business cycle of the asset. When combined with other techniques such as fundamental analysis, using Bollinger Bands can give systematic traders a method of choosing their buy and sell points."
Companies, like Forbes, suggests that using Bollinger Bands is a simple and often an effective strategy but stop-loss orders should be used to mitigate losses from market pressure.
Security prices have no known statistical distribution, normal or otherwise; they are known to have fat tails, compared to the Normal.
The sample size typically used, 20, is too small for conclusions derived from statistical techniques like the Central Limit Theorem to be reliable. Such techniques usually require the sample to be independent and identically distributed which is not the case for a time series like security prices.
For these three primary reasons, it is incorrect to assume that the percentage of the data outside the Bollinger Bands will always be limited to a certain amount. So, instead of finding about 95% of the data inside the bands, as would be the expectation with the default parameters if the data were normally distributed, one will typically find less; how much less is a function of the security's volatility.
These are a few of the great methods for using Bollinger Bands. I am not one to use many indicators on my charts due to the cluttered feeling I get. I keep price, volume, and Bollinger bands on the chart. Keep it simple. If you feel the need to add additional indicators to confirm your analysis, make sure to test it out thoroughly in advance to putting any trades on.
As one the most popular technical-analysis indicators, using Bollinger Bands have become crucial to many technically oriented traders. By extending their functionality through the use of Bollinger band "bands", traders can achieve a greater level of analytical sophistication using this simple and elegant tool for both trending and fading strategies.
The Bottom Line
While every strategy has its drawbacks, using Bollinger Bands have become one of the most useful and commonly used tools in spotlighting extreme short-term prices in a security. Buying when stock prices cross below the lower Bollinger band often helps traders take advantage of oversold conditions and profit when the stock price moves back up toward the center moving-average line.
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