Bollinger Bands

Implication

Bullish: When the price closes more than 2 standard deviations below the 20 period moving average of price, a bullish event is generated.

Bearish: When the price closes more than 2 standard deviations above the 20 period moving average of price, a bearish event is generated.

Trading Central identifies a Bollinger band event based on a condition of price over-extension leading to an expectation of reversal. Some enhanced interpretations of Bollinger bands require secondary inputs such as RSI to validate a continuation or reversal position strategy. Refer to the Trading Considerations section below for further information regarding enhanced strategies for Bollinger bands.

Description

Developed in the early 1980's by John Bollinger, Bollinger bands were one of the first adaptive volatility envelope tools. Rather than fixed percentage envelopes being drawn above and below the moving average, Bollinger bands are calculated based on the standard deviation of an instrument's closing price.

Bollinger bands use standard deviation and a simple moving average to help traders determine buy and sell events, or to help confirm other patterns. A price chart that uses Bollinger bands displays four lines; price, the upper and lower Bollinger bands, and the moving average.

The upper and lower Bollinger bands typically appear 2 standard deviations above and below the 20-day moving average. Trading Central supports these typical settings.

For shorter-term trends, some technical analysts prefer 1 1/2 standard deviations with a 10-day moving average. For longer-term trends, a 2 1/2 standard 50-day moving average may better suit their purposes.

The purpose of Bollinger bands is to provide an indication of high and low price range. By definition prices will be high at the upper band and low at the lower band. Price tends to bounce between the upper and lower Bollinger bands, but touches or penetrations can be tradable. The expansion or contraction of the band's width around the moving average indicates periods of high or low volatility respectively.

Trading Considerations

There are several successful trading strategies that are used in conjunction with Bollinger bands. Typically they involve monitoring the price action after a Bollinger band penetration, or reference to a secondary indicator or oscillator to qualify the potential for a continuation or reversal of the present price trend. Some traders watch for a succession of Bollinger band touches to track upside or downside momentum.

Periods of rising price volatility lead to a widening of the Bollinger bands, and conversely, low price volatility causes tightening of the bands. Because there is a tendency for bands to alternate between expansion and contraction phases, some traders look for unusually wide bands and interpret that as a sign of trend reversal. Conversely, extremely narrow bands can be an indication that supply and demand are in a fine state of balance and can be easily upset, potentially leading to the initiation of a new and powerful trend move.

Both John Bollinger and the classic text "Technical Analysis of Stock Trends" by Edwards and Mcgee suggest using Bollinger bands penetrations as signals that are qualified by another indicator or oscillator. A common Bollinger bands and Relative Strength Index (RSI) based strategy is:

• "When price touches or penetrates the upper Bollinger Band, and the RSI is below 70, it is an indication that the trend will continue. Conversely, when price touches or penetrates the lower Bollinger Band, and the RSI is above 30, it indicates the trend should continue."
• "If a price touches or penetrates the upper Bollinger Band and the RSI is above 70 (possibly approaching 80) the trend may reverse and decline. On the other hand, if a price touches or penetrates the lower Bollinger Band and the RSI is below 30 (possibly approaching 20) it indicates the trend may reverse and move upward."

In "Technical Analysis Explained", Martin J. Pring suggests that you can determine whether a price reversal is imminent by observing how price behaves following the initial Bollinger band crossing. He states: "If the price makes several failed attempts to cross or touch a band, but in doing so traces out a classic reversal price formation, you can expect a price trend reversal."

In "The Master Swing Trader", Alan S. Farley suggests that a move that leads to a price bar extending over 50% beyond the Bollinger band is over-extended and encountering resistance and thus overdue for a reversal. This is the interpretation that Trading Central implements.