Tech Studies - Bollinger Bands: Bollinger Bands
Bollinger Bands are a type of envelope that are plotted at standard deviation levels above and below a moving average. This produces an effect of having the bands widen during periods of higher volatility and contract during less volatile periods. Bollinger bands allow for an understanding of changes in supply and demand for the underlying security as a quick view. During periods of lower volatility, in sideways moving markets, the bands contract toward the moving average. When the market is in a period of indecision, between major news or prior to the maturing of market perception, volatility drops off. Often there is a build up of stop orders outside of the current trading
range to protect against a breakout of the current trading range. If this period of lower volatility lasts for a long time, the resulting breakout can be fairly strong as resolution creates an imbalance in supply and demand as well as the build up of orders outside the previous trading range. This may lead to trading opportunity.
Using our critical day with Bollinger bands can be valuable when added to your own trading platforms. Critical Days on the graph below are shown with Blue and Red dots. The blue dots, above or below the price plot, indicate successful critical days. Red dots indicate failures. A successful critical day indicates that the short trend did reverse, as expected by members, going into that period. Bollinger bands are shown on the graph with interpretation following the graph. Notice the Graph is the Russell 2000 index. Critical days have a wide application for the markets by nature and can be helpful in developing trading strategies and timing for stocks, options and futures. A look at Bollinger Band Interpretation
On the graph you can see the overall trend of the market and a quick reference for supply and demand as well as support and resistance area's by using a 20 day moving average and 2 standard deviations in calculating the Bollinger Bands. The Nasdaq Composite Index moves toward the upper band in mid January. A break from the upper band is an indication of slowing momentum and can provide evidence of the relative enthusiasms of buyers and sellers. Nasdaq then breaks through the center moving average giving a bearish signal through a lack of support evidence at the 20 day moving average. A retreat to the lower boundary of the Bollinger band continues for some time with no break of the 20 day MA from below for the period of the graph. This builds supporting evidence of price trend. Other characteristics of the Bollinger Bands and possible methods of interpreting price action for a stock or index follows below:
When price is trading near the upper or lower Bollinger band line, there is a possibility of trend reversal. This is not always the case and other methods of confirming the trend should be in use. When the price moves outside the bands, a continuation of the trend is implied. Again this observation needs to have other methods of confirmation. A good conformational indicator is On Balanced Volume. When price moves outside the bands and is supported by confirming evidence from the On Balanced Volume indicator, there is a greater likelihood of a continuation of the trend. Bollinger states that his bands do not give buy or sell signals but rather are indications of overbought and oversold based on recent market valuation levels. Bollinger suggests using Relative Strength Indicator and On Balanced Volume as confirming indicators for Bollinger Bands. A move that originates at one band tends to go all the way to the other band. This is helpful in identifying price projections. Again confirmation of Bollinger band activity should be made using indicators and varying data that are not significantly co-related. General fundamental understanding, awareness of critical day research and a knowledge of the uses of Bollinger bands and other indicators can greatly improve your trading performance.