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Bollinger Bands are one of the most widely used and well regarded technical indicators around. One of the reasons for their popularity is that they are a directional analysis tool as well as a measure of volatility.
Bollinger Bands – which get their name from John Bollinger – work by calculating moving average and standard deviation levels over the same rolling period. The standard deviation is then added to and subtracted from the moving average to form upper and lower bands. Typical moving average periods are 20, 13 and 8, whilst the most popular standard deviation level is 2.
The idea is that the bands contain the predominant price action. Moves beyond the bands signal trend strength or potential reversals. Bollinger bands are a double-edged sword.
Bearing in mind the old bell curve that many of us haven’t used since school, we know that 3 standard deviations should account for all but a few occurrences with either normal or lognormal distribution. Don’t let the term “standard deviation” fool you, however. Moves of 3 standard deviations or greater are far too common for stocks to be normally or even log-normally distributed.
Take a look at the chart for Sonus Networks below (SONS:NASD). In the panic of late July, SONS gapped down well outside the popular 2 standard deviation setting.
Chart 1 – SONS 20-2 Bollinger Bands
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Changing the parameters in Chart 2, we can see that SONS moved almost 7 standard deviations to its low when compared to the 20 previous closes.
Chart 2 – SONS 20-7 Bollinger Bands
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It is fair to say that 20 is too small a sample to accurately establish standard deviation levels for a stock. Yet even with more data there are examples of stocks that move 10 standard deviations in a single bar. The point is that Bollinger Bands are best used as a gauge rather than a definite point of resistance or support.
With larger data samples, we can use Bollinger Bands to highlight extreme price levels. Chart 3 below uses a longer term 200 period average with 3 standard deviations. These settings will contain far more price action.
Chart 3 – FII 200-3 Bollinger Bands
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We can use these new Bollinger Band settings with Elliott Wave theory to find stocks that are potentially at the end of a move. The fact that Federated Investor Inc (FII) tagged the upper bands in a Wave 5 with RSI divergence and a reversal pattern on the last bar suggests that FII reached a price extreme.
In my view, gauging price levels – rather than providing absolute resistance or support levels – is the Bollinger Band’s greatest strength.
Happy Trading
Jordan Craw
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