TRADING Basics

Indicator Insight:

BY ACTIVE TRADER STAFF

Bollinger Bands

FIGURE 1 BOLLINGER BANDS VS. MOVING AVERAGE ENVELOPE

While moving average envelopes (top chart) move higher or lower together,
Bollinger Bands can move in opposite directions (lower chart).

S&P index-tracking stock (SPY), daily

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ollinger Bands are a type of

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Moving average envelope
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trading envelope consisting
moves in tandem
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of lines plotted above and
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below a moving average
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designed to capture a markets typical
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price fluctuations.
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The indicator is similar in concept to
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the moving average envelope (see
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Indicator
Insight,
Active
Trader
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September 2002, p. 88), with an impor79
tant difference: While moving average
envelopes plot lines a fixed percentage
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above and below the average (typically
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Bollinger Bands expand and contract
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three percent above and below a 21-day
with the market volatility
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simple moving average), Bollinger
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Bands use a statistical measurement of
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the closing prices called standard devia 85
tion (see the next section) to determine
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how far above and below the moving
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average the lines are placed.
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As a result, while the upper and lower
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lines of a moving average envelope
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always move in tandem (Figure 1, top
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24
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chart), Bollinger Bands expand (i.e., the
February
March
April
top band can rise while the bottom band
falls) during periods of increasing marSource: MetaStock
ket volatility and contract during periods
of decreasing market volatility (Figure 1,
Middle line = 20-period simple moving average of
bottom chart).
closing prices
Bollinger Bands were created by John Bollinger, CFA, CMT,
Lower band = 20-period simple moving average the president and founder of Bollinger Capital Management
2 standard deviations
(see Active Trader, April 2003, p. 60).
Standard deviation is a statistical calculation that measures
Calculation
how far values deviate from an average value in this case,
The classic approach to this indicator is to place the upper and
how far prices stray from a 20-day moving average. The proplower Bollinger Bands two standard deviations above and
er use of standard deviation calls for a sample of at least 30
below a 20-period moving average.
observations, in which case, statistically, 95 percent of values
will fall within two standard deviations of the average value.
Upper band = 20-period simple moving average +
Because Bollinger Bands typically use just 20 days of closing
2 standard deviations
prices, the bands will generally encompass 88 to 89 percent of
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www.activetradermag.com July 2003 ACTIVE TRADER

FIGURE 2 CONTRACTING BOLLINGER BANDS

When Bollinger Bands contract, as was the case beginning in mid-February, it
can be a sign a higher-volatility trend move is about to begin.
Nasdaq 100 index-tracking stock (QQQ), daily

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Bollinger Bands are wide

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Bollinger Bands narrow

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25.5
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the price action. (To learn more about

standard deviation, see the Web Extra
for this article at www.activetradermag.com between June 10 and June 30,
2003.)

A nice trend run

follows the narrow
Bollinger Bands

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24.0
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Interpretation and use

Bollinger Bands provide two important
pieces of information: first, whether
volatility is high or low, which can be
determined by measuring the difference
or the width between the upper and
lower band; and second, whether prices
are high or low relative to past prices as
well as within the context of the
Bollinger Bands themselves.
Watching for low-volatility conditions is a well-known trading technique,
because low volatility often precedes
high-volatility trend runs. For example,
Figure 2 shows the Nasdaq 100 indextracking stock (QQQ). During January
and into mid-February, the Bollinger
Bands were running at a nearly $3.50
differential. Then, as the market moved
into a lower-volatility trading range in
February, the Bollinger Bands narrowed
to a $2 difference. This volatility contraction was a sign to look for an emerging trend move. In this case, the market
broke through resistance at $25.50, and
sprinted back to the January highs.
Tags of the upper and lower Bollinger
Bands can indicate temporary overbought and oversold conditions, but
Bollinger stresses these events are not
automatic reversal trade signals. In a
strong uptrend, for example, price can
repeatedly tag the upper Bollinger Band,
similar to the way an oscillator will stay
above its overbought threshold in the
same circumstances. As a result, other
information must be consulted to provide
context for the Bollinger Band signals.
continued on p. 79

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Bollinger Bands are wide

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3
10
February

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3
10
March

17

24

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7
April

Source: MetaStock

FIGURE 3 HEAD FAKES

Contracting Bollinger Bands can sometimes lead to false breakouts. Here,
new lows established after the bands contracted appear to signal the start
of a downtrend in early March. However, it was just a head fake and price
quickly reversed.
Bed, Bath & Beyond (BBBY), daily

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Support point

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Head fake
Money Flow Index

Bullish readings
greater than 50

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50
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30

Divergence
December

2003

February

March

April

Source: MetaStock

ACTIVE TRADER July 2003 www.activetradermag.com

75

Indicator Insight continued from p. 75

A basic technique is to combine
Bollinger Bands with another indicator.
Bollinger, for example, considers volume
analysis to be a valuable aid. Figure 3 (p.
75) is Bed Bath and Beyond (BBBY) with
Bollinger Bands and the Money Flow
Index (MFI), which is similar to the relative strength index oscillator (RSI, see

lied sharply, driving the MFI into bullish

territory (readings above 50). The stock
advanced an additional $6. The successive tags of the upper Bollinger Band following the head fake were a sign of
strength although the overbought
condition they indicated created a temporary pullback to the moving average,

FIGURE 4 THE IMPORTANCE OF THE MOVING AVERAGE

Strong trends are often characterized by price moving between the moving
average and upper/lower band. The moving average functions as a basis
support or resistance level, depending on the direction of the trend.
S&P index-tracking stock (SPY), daily

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Downtrend,
moving average
acts as resistance

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Uptrend,
moving average
acts as support

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3
10
February

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3
10
March

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7
April

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Source: MetaStock

Indicator Insight, Active Trader, August

2001, p. 88), with an additional volume
component.
Figure 3 shows the MFI diverging as
the price fell to new lows in March. This
chart contains an example of a phenomenon Bollinger refers to as the head fake
a false breakout following a narrowing of the Bollinger Bands. During late
February, the Bollinger Bands narrowed
and the market fell to a new low.
However, price quickly reversed and ral-

which then acted as support (a common

occurrence during a trend).
This highlights another valuable use
of Bollinger Bands. The moving average
provides a key point to watch during
trends. While in a strong uptrend, price
tends to trade between the upper band
and the 20-day moving average.
Conversely, during a strong downtrend,
price generally fluctuates between the
moving average and the lower band.
For example, in Figure 4 (above) the

ACTIVE TRADER July 2003 www.activetradermag.com

market traded temporarily above the

falling 20-day moving average (the mid dle band) and then fell back to the lower
band. Then, when the trend reversed,
there were buying opportunities where
the price temporarily fell below the rising 20-day moving average.

Key points
Although software programs allow you
to adjust parameters, Bollinger suggests
using the default indicator values a
20-period moving average with bands
set two standard deviations above and
below the average at all times (see
Relatively speaking: John Bollinger,
Active Trader, p. 60). He advises traders
who wish to adjust the indicator to
shorter or longer time frames simply to
use shorter or longer bars (e.g., 60minute bars or weekly bars, etc.).
Using confirming technical tools or
chart patterns is an important element of
using this indicator. Bollinger Bands are
not a tool to be used in isolation. Pick
indicators that compliment the Bollinger
Bands, but do not replicate the same
information. For example, using RSI and
stochastics (another oscillator) along
with Bollinger Bands simply gives you
the same information from the two oscillators. Combine volume, an oscillator
and the Bollinger Bands for a morerounded market perspective.

Bottom line
By providing a framework designed to
contain nearly 90 percent of price fluctuations, Bollinger Bands are a tool for
identifying whether price is relatively
low or high at a given time. They can be
used for setting price targets, identifying
swing points and exhaustion moves, and
pinpointing trend shifts. Probably their
strongest value, though, is the ability to
identify periods when volatility is dropping (reflected by narrowing bands) or
exceptionally low, as this can set the
stage for a good trend.
Like most technical indicators, Bollinger
Bands are not stand-alone tools, and
tags of the bands should not be interpreted as reversal signals without taking
other evidence into account. Confirming
information, such as volume and price
patterns, can be used to determine the
meaning of a Bollinger Band signal.
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