Bollinger Bands

Bollinger bands are the result of the work of John Bollinger, a well known US technician. The bands are an indicator of the volatility of a particular index or stock. Volatility can be described as the rate of change in price over a specific period. Price that rises or falls substantially in a short period of time is described as experiencing high volatility. When price consolidates (the process of seeking fair value) after a move of some substance, the price makes less headway over the same period that saw a more rapid movement. This is described as low volatility.

A basic market truth - All price breakouts begin from a period of low volatility.

The structure of the Bollinger Bands is to use the standard deviation formula applied to the distance of the closing price of the stock or index to the position of a 20 day moving average. Bollinger used a twenty period moving average and applied two standard deviations above and below the moving average. One standard deviation from an average tends to capture 68% of the events being measured. Two standard deviations capture some 95% of the events. The structure, applied to market action, should see 95% the market prices contained with the average. An upper band, 2 standard deviations above the moving average, and a lower band 2 standard deviations below the moving average, should largely encompass 95% of the price action.

The price chart for Suncorp demonstrates the principles involved. Note the tendency for price to consolidate around the 20 period moving average line and for the market to find support or resistance at these levels. Widening bands means volatility is increasing. High volatility will see the profit, or loss, achieved in a shorter time frame and that results in a greater annualised percentage return. This is the same principle as a business seeking to turnover stock as many times as possible in a particular time frame. Lower volatility precedes a breakout and suggests that finding a reference point for an entry could be a profitable use of time. The position of price relative to the bands also provides some awareness of impending price action.

Note the violation of the upper band and, in the first instance, the rapid retreat of price back inside the bands. The last price bar for Suncorp is also well above the upper band suggesting that a retracement of price is very likely. The date of the last bar is 23rd February 2007 and this is being written Sunday 25th February 2007. The outcome is not yet known. Example of a Trade

The horizontal plane has defined the upper boundary of the consolidation with the second touch of the horizontal line providing confirmation that the band is a “plane” of resistance. The “setup” allows the use of a narrow band (1%) because at the time when a possible entry signal was near, the bands had commenced to expand noticeably. The risk was 21 cents and the likely minimum profit was $1.00. A $10,000 account could carry a 400 unit (CFDs) for a $400.00 profit over a ten day period. Note the second entry on the break out of the symmetrical triangle.

Another very powerful signal occurs when the market makes a top or bottom on the bands, retreats away from the bands and then reverses back to the band creating a double top or bottom. Under these circumstances, reversal of some substance is most likely.