Bollinger Bands

What is the Bollinger Bands?

Bollinger Bands are a set technical indicator and trading tool created by John Bollinger in the early 1980s. The Bollinger Bands are therefore being used to measure the volatility of the market. When the market is quiet, the bands contract; but when the market is LOUD, the bands expand. when the price was quiet, the bands close up together, but when the price moved up, the bands spread apart.

The other purpose of the Bollinger Bands is to provide an indication of the high and low of the price. It is clear that prices are high at the upper band and low at the lower band. 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.

The Bollinger Bands consist of a set of three curves drawn in relation to prices of the currency. The middle band is a shows the intermediate-term trend, usually it is a simple moving average, which serves as the basis for the upper and lower band. The interval between the upper and lower bands and the middle band is determined by volatility, typically a standard deviation of the same data that were used for the average. The default parameters used for the Bollinger Bands are, 20 period simple moving average and standard deviations of 2, and this parameters may be adjusted accordingly to your trading needs.

There are many ways to use Bollinger Bands, the following are a few rules that serve as a good guide to the use of the Bollinger Bands.

1. Bollinger Bands provide a relative definition of high and low.

2. That relative definition can be used to compare price action and indicator
to arrive at rigorous buy and sell decisions.

3. Appropriate indicators can be derived from momentum, volume, sentiment, open
interest, inter-market data, etc.

4. Volatility and trend have already been deployed in the construction of Bollinger
Bands, so their use for confirmation of price action is not recommended.

5. The indicators used for confirmation should not be directly related to one another.
Two indicators from the same category do not increase confirmation. Avoid colinearity.

6. Bollinger Bands can also be used to clarify pure price patterns such as M-type;
tops and W-type bottoms, momentum shifts, etc.

7. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger
Band.

8. Closes outside the Bollinger Bands can be continuation signals, not reversal
signals--as is demonstrated by the use of Bollinger Bands in some very successful
volatility-breakout systems.

9. The default parameters of 20 periods for the moving average and standard
deviation calculations, and two standard deviations for the bandwidth are just
that, defaults. The actual parameters needed for any given market/task may be
different.

10. The average deployed should not be the best one for crossovers. Rather, it
should be descriptive of the intermediate-term trend.

11. If the average is lengthened the number of standard deviations needs to be
increased simultaneously; from 2 at 20 periods, to 2.1 at 50 periods. Likewise,
if the average is shortened the number of standard deviations should be reduced;
from 2 at 20 periods, to 1.9 at 10 periods.

12. Bollinger Bands are based upon a simple moving average. This is because a
simple moving average is used in the standard deviation calculation and we wish
to be logically consistent.

13. Be careful about making statistical assumptions based on the use of the standard
deviation calculation in the construction of the bands. The sample size in most
deployments of Bollinger Bands is too small for statistical significance and the
distributions involved are rarely normal.

14. Indicators can be normalized with %b, eliminating fixed thresholds in the process.

15. Finally, tags of the bands are just that, tags not signals. A tag of the upper
Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger
Band is NOT in-and-of-itself a buy signal.

These 15 rules on the use of Bollinger Bands are given with compliments from John Bollinger, CFA, CMT. You may also like to visit him at http://www.bollingerbands.com/ to learn more about the Bollinger Bands.