It was very subtle, but you can see how the bands were coiling tighter and tighter from September through December. Pairing the Bollinger Band width indicator with Bollinger Bands is like combining the perfect red wine and meat combo you can find. It's one of the most popular indicators. Conversely, you sell when the stock tests the high of the range and the upper band. I had presented a chart showing an unconfirmed tag of my upper band and explained that the first down day would generate a sell signal.
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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. In Spring , Bollinger introduced three new indicators based on Bollinger Bands. Bandwidth tells how wide the Bollinger Bands are on a normalized basis. Writing the same symbols as before, and middleBB for the moving average, or middle Bollinger Band:.
Uses for bandwidth include identification of opportunities arising from relative extremes in volatility and trend identification. The use of Bollinger Bands varies widely among traders. Some traders buy when price touches the lower Bollinger Band and exit when price touches the moving average in the center of the bands.
Other traders buy when price breaks above the upper Bollinger Band or sell when price falls below the lower Bollinger Band. When the bands lie close together, a period of low volatility is indicated. Traders are often inclined to use Bollinger Bands with other indicators to confirm price action.
In particular, the use of oscillator-like Bollinger Bands will often be coupled with a non-oscillator indicator-like chart patterns or a trendline.
If these indicators confirm the recommendation of the Bollinger Bands, the trader will have greater conviction that the bands are predicting correct price action in relation to market volatility. Various studies of the effectiveness of the Bollinger Band strategy have been performed with mixed results.
In , Lento et al. The authors did, however, find that a simple reversal of the strategy "contrarian Bollinger Band" produced positive returns in a variety of markets.
Similar results were found in another study, which concluded that Bollinger Band trading strategies may be effective in the Chinese marketplace, stating: A recent study examined the application of Bollinger Band trading strategies combined with the ADX for Equity Market indices with similar results. A paper from uses Bollinger Bands to reduce variance in a Monte Carlo simulation used to forecast the Canadian treasury bill yield curve.
In , Butler et al. Nor would you use a buzz saw to drive in nails. Just like in trading, some trading tools and indicators are best used in particular environments or situations. So, the more tools you have, the better you can adapt to the ever-changing market environment. For this lesson, as you learn about these indicators, think of each as a new tool that you can add to that toolbox of yours. You might even find one that you understand and comfortable enough to master on its own.
Now, enough about tools already! When the market is quiet, the bands contract and when the market is LOUD, the bands expand.
Notice on the chart below that when price is quiet, the bands are close together. One day I copied a volatility formula down a column of data and noticed that volatility was changing over time. Seeing that, I wondered if volatility couldn't be used to set the width of trading bands. That idea may seem obvious now, but at the time it was a leap of faith. At that time volatility was thought to be a static quantity, a property of a security, and that if it changed at all, it did so only in a very long-term sense, over the life of a company for example.
Today we know the volatility is a dynamic quantity, indeed very dynamic. After some experimentation I settled on the formulation we know today, an n period moving average with bands drawn above and below at intervals determined by a multiple of standard deviation We use the population calculation for standard deviation. The defaults today are the same as they were 35 years ago, 20 periods for the moving average with the bands set at plus and minus two standard deviations of the same data used for the average.
I had presented a chart showing an unconfirmed tag of my upper band and explained that the first down day would generate a sell signal. Bill then asked me what I called those lines around the price structure, a question that I was totally unprepared for, so I blurted out the alliteratively obvious choice: They are curves drawn in and around the price structure usually consisting of a moving average the middle band , an upper band, and a lower band that answer the question as to whether prices are high or low on a relative basis.
Bollinger Bands work best when the middle band is chosen to reflect the intermediate-term trend, so that trend information is combined with relative price level data. For many years that was the state of the art: Here are a couple of practical examples of the usage of Bollinger Bands and the classic Bollinger Band tools along with a volume indicator, Intraday Intensity:.
Click chart to enlarge. On 20 July prices tagged the upper Bollinger Band while day Intraday Intensity was deep in negative territory setting up a sell alert.
The first down day was the sell signal and entry. The red triangle is a negative PowerShift. We have come a long way since the bands were developed.