Bollinger Bands – Clearly a Strong Choice for the Advanced Trader

Understanding the Bands

Bollinger Bands are the brainchild of Bollinger Capital Management’s founder and former CNBC analyst John Bollinger. They provide insight into an issue that is clearly critical to traders – is the price of a stock (or other financial instrument) relatively high or relatively low? The bands also reveal how the volatility of stock has changed over time, which can also be an indicator of future price behavior.

The bands themselves are simply three lines overlaid on a share price chart. The middle band is a twenty day moving average of the stock price. The upper band is the twenty day moving average plus two standard deviations, while the lower band is the twenty day moving average minus two standard deviations. The price of a stock generally stays within the channel formed by the upper and lower bands. If the price is close to the upper band, the stock is considered to be expensive relative to its recent past, while a price near the lower band is considered relatively cheap. This relative expense can also be stated using a measure called %b.

%b = (Last - Lower Bollinger Band) / (Upper Bollinger Band - Lower Bollinger Band)

The vertical distance between the upper and lower bands conveys information about the relative volatility of the stock. A narrowing gap between the bands indicates decreasing volatility or less variation in the price of the stock. An increasing gap implies the opposite. This information is of particular importance to options traders as the value of options is dependent on implied volatility (expectations about future volatility). There is a specific measure of relative volatility called the Bollinger Bandwidth.

BandWidth = (Upper Bollinger Band - Lower Bollinger Band) / Middle Bollinger Band

It is important to note that despite the use of standard deviations to create Bollinger Bands, it is not possible to draw valid statistical conclusions from them. There is a common misconception that some fixed proportion of prices will fall between the bands. In fact, there is no genuine statistical basis for this idea. It is better is to think of the upper and lower bands simply as rough, though widely acknowledged, guidelines of what constitutes relatively cheap or expensive.

Trading the Bands

Traders utilize Bollinger Bands in wildly varying ways. A simple strategy is to buy when the price touches the lower band, and sell when it hits the moving average or upper band. This approach is not without difficulties. Bollinger himself has pointed out that, "Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band," which can be distressing for any trader who buys when the price first touched the lower band.

However, the simple buy low, sell high approach is not without followers. Channel traders seek out stocks that exhibit reasonably low bandwidth and relatively horizontal bands. These reasonably stable stocks are said to trade within a ‘channel’ and can thus be bought and sold repeatedly for modest profits, but at relatively low risk, as the price oscillates within the channel