Understanding Bollinger Bands

by Gary
I’m Dan Fitzpatrick at StockMarketMentor.com and OptionMarketMentor.com; hope you’ll check both of those out. I want to talk about Bollinger Bands. This is a very, very popular indicator; the reason it’s popular is because it works; this is an indicator that works, it gives you a real sense of price action, direction, where trends are, when the trend is weakening, when the trend is strengthening, and things like that. They’re also pretty misunderstood; you know, buy when it’s outside the lower band and sell when it’s outside the upper band. That’s pretty simplistic so I want to go into some detail here and hope that this will help you understand how to use this very, very popular and useful indicator; originated by John Bollinger he wrote a book, “Bollinger on Bollinger Bands,” which is really the ultimate bible on Bollinger Bands, so I definitely recommend you check that out. Here’s the “Reader’s Digest” version. What are they? These are adaptive trading bands that reflect changes in volatility and provide a clearer picture of the true extent of price movement. Think about them as trend lines, they’re adaptive trend lines with a volatility component so rather than be straight up there’s an upward channel, or straight down, or trending down, there’s a downward channel. Instead you get these Bollinger Bands that flop all around; it seems like they don’t make much sense until you really understand what they are. So again, just think about Bollinger Bands as trend lines defining support in resistance. Let’s take a look here. Okay, calculating them, it’s standard deviation; it’s a statistical methodology, a very, very complex calculation. A lot of times when I teach this indicator I show a big chart or a big graph of exactly what standard deviation calculation is; just to scare people and tell them, finally, guess what? You don’t need to know that, I’m going to spare you the details on that, instead let’s just say that it’s a statistical calculation to measure dispersion. In other words, how spread out, and we’re talking about just closing prices in the market not intraday highs or lows or averages or anything like that; were just talking about closing prices, how spread out are they around a specific moving average? Typically you use the 20-period moving average, you can use the 50-period moving average, you can use the 200, you can use whatever period you want. I like to keep it straight and simple 20-period. So if it’s a daily chart the 20-day moving average, if it’s a weekly chart the 20-week moving average. So you look at that moving average, and again, moving averages can be moving higher, they can be moving lower, they can be trading sideways, all we want to know is we look at that moving average and how close or far away are all the closing prices relative to that moving average? This is obvious, but sometimes it’s obvious after it’s explained. If it’s a 20-period moving average all we care about, the only thing that the bands are calculated on is those last 20-periods, those last 20-data points. So if we’re talking about days, I’m just going to revert to that, days, the last 20-days. As we get a new day on to the front end, the 20th day pops off the back end, so it’s a walking set of prices. So how far apart or close together are most of those prices? The larger the standard deviation, the greater the containment of prices. Put another way, these Bollinger Bands are dynamic, they spread out, they get narrow, that’s called a volatility squeeze, they get wide, that’s called the volatility expansion, narrow again. So why do they do this? Because they adapt to the prices. If prices are all over the place, just all over, then the Bollinger Bands widen out because they’ve got to contain those prices, if the prices are really kind of chopping around in basically the same level the Bollinger Bands narrow. Why? Because they don’t have to be wide; all they do is they want to contain the prices, they want to wrap themselves around the prices, and that’s why we get this widening and narrowing of these Bollinger Bands. So let’s look at it, and I’ll get to charts in just a minute, I’ve got to ask you to bear with me on some of this so you can truly understand what’s happening here. Okay, one standard deviation, this is the midline right here, this would be the value of that 20-period moving average. This is one standard deviation above; this is one standard deviation below. Most of the prices are going to be hovering right around this midline, the 20-period moving average. Well, in order to contain, if you just have one standard deviation, you’re ultimately going to contain only about 68 we’ll call it 70 percent of the closing price data, so there’s going to be prices that are outside the band’s quite a ways, frankly to a point where they really don’t do you much good. Two standard deviations, that’s the normal. Statistically they’re supposed to contain 95 percent of the closing data. Actually, and this is a study done by John Bollinger, they contain about 90 percent. So on a two standard deviation setting for Bollinger Bands about 90 percent of all the closes are going to be inside the bands and this is important because again, if the prices are all over the place they are up and down and all around, then those bands are going to have to be really wide in order to contain 89 or 90 percent. On the other hand if the prices are all kind of clustered, let me get rid of this here, if the prices are all kind of clustered in one little general area, then what happens? Those Bollinger Bands don’t have to be so wide in order to contain 90 percent of the prices. Now if we go out to three standard deviations, and this is a whole different trading methodology here that I talk about at Stock Market Mentor sometimes, and certainly in my live workshops. Three standard deviations, when you got these Bollinger Bands that are really wide, three standard deviations, they contain 99 percent of the closing price data, only 1 percent, 1 out of every 100-days statistically, is going to be outside the bands. By the way when you see that 1 percent, what do you think is probably going to happen maybe the next day or the day after that? Well that price is going to fall back within the Bollinger Bands because, statistically, that’s what it does. So at this point, and by the way, that’s not a simple trade either, you can’t just say, “Okay well if the price closes I use three standard deviations, a setting of three as opposed to two, if the price is above the upper band that means I get to short the stock, if the price is below the lower band then that means I get to go long the stock because the stocks definitely going back up.” No, it’s more complicated than that because of the width of the bands. Bands are adaptive to volatility so certain conditions this is absolutely a winning trade. Up above the third standard deviation upper Bollinger Band, short that stock. Down below the third standard deviation lower Bollinger Band, go long that stock. Other conditions have to exist in order for that to be a very, very high probability trade but that’s for another video. Here we’re just looking at the basics. Now bear with me here; this is a how we look at them. Bollinger Band calculations, 20-period moving average, that’s the midline, 20-period simple moving average, 20-period simple moving average plus to standard deviations, that’s the upper band, 20-period simple moving average minus to standard deviations, that’s the lower band. So the prices, ideally, 90 percent of them should be within this range here. Here’s where it really gets interesting and this is why you have to know this. It’s a relative indicator on an absolute indicator, a nominal indicator. It’s easy, $45.00 is always higher than $44.00; sometimes when you’re maybe in first grade that’s not always the case, but for most of us we get to a point where we know if a stock is $45.00 that would be $1.00 higher than $44.00; $100.00 is always lower than a $110.00. Bollinger Bands are different, $45.00 actually might be lower than $44.00, $100.00 might be higher than $110.00. Why? Because we’re gauging high and low relative to the Bollinger Bands, relative to that. What’s high relative to the Bollinger Bands, what ‘s low relative to the Bollinger Bands? Absolute, just easy, count from zero to whatever you’re at and the number that you come to sooner, that’s lower, okay? It’s really easy. So we’re really talking about relative here, what are prices relative to these Bollinger Bands? So we’ll look at it this way, higher highs or higher lows. Absolutely, on an absolute basis these are higher highs, these are higher lows, until finally there’s a break of the trend here. We put in a 20-period moving average in this same chart; that’s basically right through the middle. But there is some volatility here, you can see the moving average moves up and down just a little bit and so the upper Bollinger Band could be constructed this way. Now, look how close this last high is, remember higher highs, all of these are higher highs, but look how close this last high is to the upper Bollinger Band, it’s about right on the money. The next high, it’s higher than the last, but it’s lower relative to the Bollinger Band. The next one is higher than the last so we’ve got this trend line here of higher highs. On the Bollinger Bands though, you can see they’re actually lower highs, lower relative to the upper band, here, basically right on the money, here a little bit below, here a lot below. So if you weren’t looking at this in the context of Bollinger Bands but were instead just looking at it on a price, you would be surprised, you’d be surprised when this stock broke trend. But if you look at it relative to these Bollinger Bands, to the upper band, you would see that we’ve actually had some pretty fair warning that the price was deviating away from these highs, and so you get, basically, an early warning sign that there’s a problem with the price. Now if we look at the lower Bollinger Band we put this in there, again, higher lows, what’s happening though? You can see it relative to the first one; the price is well above the lower band. That’s a good thing. Next one, the price is closer to the lower band so it’s kind of lower relative to the first one. And then next we’ve got one where it’s just about right on the lower band, so this is again, one of those situations where the price is doing one thing but relative to these Bollinger Bands what would normally be seen as higher lows are actually lower lows relative to this lower band. Now we put them both together and you can see what’s happening; the price, even though it’s higher, has actually been dropping away for a while and even though the price here, even though it’s higher, has actually been coming in closer to where it was going to break down, so you would have had again, an early warning sign that this price was going to break down if you had been looking at this in terms of Bollinger Bands. Let’s look at a couple charts. Now here’s an old chart of Google ( $GOOG Google Inc ). You can see this stock trending down, where is the first higher high? You’ve got a look and say there, this is all within the trend here, downtrend, and then finally we get a higher, higher, we buy the pull back here, and then we ride this on to victory. But, if you instead slap some Bollinger Bands on there what you will see is relative to the 20-period moving average it had been banging against the 20-period here, this was your higher high, right here, even though it still conformed to this trend line, this gave you the early indication that this stock was turning; it gave you and early indication that this close above the 20-period moving average, well that was different, now you get the pullback on the first sign that this stocks moving higher, that’s when you buy the stock, and while I’m at it here look at how this was behaving relative to the lower band, stock had been basically walking down along the lower band, just staying right inside but on the lower end of it, suddenly the price starts to trade above the lower band, finally on this pullback, the stock was noticeably above the lower band; a totally different characteristic than we had back here. So this is really how you look at these Bollinger Bands. By the way, just look and see what’s happening here, upper band well above these prices, lower Bollinger Band, that was tagged there so now we’re right in between, so let’s just kind of do a little quick theoretical trade here. You know when you buy this stock is not when it just breaks out above this level, above this last resistance level, but when it actually breaks out above the upper band, that’s an indication that, once again, the price is changing, the price action is changing. Why? Well, because the last time the stock hit the upper band and actually exceeded it was here. Ever since then it’s never come and threatened the upper band. So when the stock actually pushes above the band again that gives you an indication that the trend is continuing. Now let’s look at the lows. Here’s a chart of Fluor ( $FLR Fluor Corporation (NEW) ). Where’s the higher low, the first higher low? Well that would be here, wouldn’t it, because we can see low, lower low, lower low still. Well, you know where I’m going with this. Now we put on these Bollinger Bands and you can see that this was actually a higher low, a higher relative low, an absolute low, nominal low, price low, certainly, this was a lower price, but relative to the Bollinger Bands this was contained by the lower Bollinger Band, this was not so this was your indication, this higher relative low was your indication that this downtrend in Fluor ( $FLR Fluor Corporation (NEW) ) was ending and it was time to start going long; close your shorts, start to go long. If you don’t do that you going to loose your shorts or at least your shirt, what you do with your shorts, I don’t really care. So let’s look and see how we could have traded this back in the, you know the early days of the new millennium here when the market was really in the toilet. I made these trades; a lot of people did if they knew how to use these Bollinger Bands. You can see the three big lows here, okay, just simple price action. Now let’s look at them with Bollinger Bands, we’re zooming in here a little bit, look at these three lows relative to the lower Bollinger Band, well below the lower Bollinger Band. Here, a lower absolute or price low but a higher relative low relative to these Bollinger Bands. Now here, well it came back down below the lower band, right? Yeah, but we got to a higher absolute low or price low than here. So you can see you can use these bands, you can look at them and find out some things about the price movement of a stock or an index or whatever, that you wouldn’t be able to see if you just looked at the price itself. So what I’m suggesting is that you use these Bollinger Bands in conjunction with just looking at the price movement. If you can use both of these together you are going to have a powerful trading tool, a very powerful trading tool. I promise you you’re going to have a better sense of which direction price is going before the other guy and it’s going to help you get into trades earlier and stay in trades longer until it’s finally time to get out. And so now we zoom back out and we look and see again, what this bottom was like; lower relative low, higher relative low. I’d say higher still or at least an absolute price low right here and then you can see what happened after this. So when you see these big massive bottoms look at them in the context of Bollinger Bands. I’ll end with this, I’ll take you to a chart of Apple ( $AAPL Apple Inc ). Everybody’s favorite stock that they love to love at one point and then they love to hate. So what are we doing here? All right, this video I’m doing at the end of the day on Friday, March 15th. I’m looking here and you see these lows, look, well below the lower Bollinger Band. A lower low still absolutely in relation to price, yes, In relation to the Bollinger Bands, not quite so much, but I’m getting nitpicky, still extended below the lower band, so I would say this low, again I could make a case for this being a higher low relative to the lower Bollinger Band, but come on, that’s results-oriented analysis, it stinks, it’s below the lower band, this more so. But, when we look at the weekly chart you get a better sense of what’s happening. Now look at these, I’ll zoom in here, by the way, this is my head and shoulder neckline that I’ve been talking about for quite awhile, like since it first started forming this thing, but look at the last three lows here. Look at the low relative to the lower Bollinger Band, well below that level, basically established the neckline. Look at this next low, basically within the lower Bollinger Band. This next low, which by the way was much lower in price than this one. This next low, lower absolute low, lower price low, within the Bollinger Bands, just about the same, just about the same as this one. So we definitely have, within these Bollinger Bands, let’s just say that downtrend, this series of lower lows, is not being maintained, it’s starting to get a little frisky. Now here, this last one, assuming this is a low, this is well above the lower Bollinger Band, even though this low here is lower than that one. So we have a series of lower price lows, but within the Bollinger Bands these are actually higher lows and so this is giving you an indication that the downtrend in Apple ( $AAPL Apple Inc ) has just about run its course and the way you would trade this stock would be, you see how the stock moves higher, see if it moves closer to the 20-period, here the 20-week moving average, and then the first pull back, if it’s higher than this one, that’s when you buy. So you don’t catch the exact bottom, but you see what’s happening, you wait for this pullback, you look at it in relation to the Bollinger Bands as well as these other prices, you buy the stock, you’re not in at the exact bottom, you’re in at little bit higher price but your risk is lower and your confidence is higher. So anyway listen, I hope that this has helped you understand Bollinger Bands. I basically do all my analysis on Stock and Option Market Mentor using Bollinger Bands and you’ll learn a lot more if you’re watching my nightly videos and my weekend videos. So if you want to learn more about those then I definitely encourage you to check out those sites. Okay, I’ll see you next time.

Free Chart Free Chart Videos Position Update Strategy Session Tutorials