Option Investor
Trader's Corner

Bollinger Bands VS. Moving Average Envelopes

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OIN SUBSCRIBER QUESTION:
I see you using trading bands, but they look different than Bollinger bands? What difference between the two kinds and is one type better than the other for general use? You got something again using Bollinger? 

RESPONSE:
Well, John (Bollinger) is a good guy and a smart market analyst. He also shares my affinity for California coastal climes and is a fun guy to go out with; and, can drink me under the table. But that's another story. 

As far as Moving Average Envelopes being "better than" Bollinger bands or vice versa, there is a use for EACH type. Otherwise, John would not be still listened to on the market and I would not still be using moving average envelopes and finding them helpful in stock index options trading. 

BOLLINGER BANDS  

The way that John Bollinger chooses to present his trading indicator is as follows: 

Bollinger Bands are a technical trading tool created in the early-80s. John saw the need for 'adaptive' trading bands, based on his observation that volatility was dynamic, not static, as was widely believed then. 

The purpose of 'Bolli' Bands is to provide a relative definition of high and low. By definition, 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 market trading decisions. 

Bollinger Bands consist of a set of three curves drawn in relation to securities prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, that serves as the base for the upper and lower bands. 

The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes: 

1. Middle Bollinger Band = a 20-period simple moving average
2. Upper Bollinger Band = Middle Bollinger Band + 2 * (multiplied by) a 20-period 'standard deviation'
3. Lower Bollinger Band = Middle Bollinger Band - 2 * a 20-period standard deviation 

Now that you're completely numb from too much technical talk, let's see what these bands look like on the current S&P 500 (SPX) chart: 

You'll note on the SPX chart below, that the bands expand upward or downward with the trend. However, when the trend goes sideways or falters, the bands start contracting. Currently, you'll see that the upper band stopped climbing and turned down to meet price. This could suggest that the index is susceptible to a decline, but there is nothing definite in this. 

One reservation I have in their use is that I find it hard to pinpoint a specific buying or selling area, as these bands expand or contract according to market volatility. This is both I think, the techniques strength and it's weakness. 

Bollinger Bands (BB) as I noted as in indicator is computed based on a 20-day moving average and is NOT shown (usually). BB combines the moving average envelope technique with a measurement of current and recent price volatility to determine placement of the upper and lower lines. 

The purpose of the BB Indicator is not that different from the "moving average envelope" indicator: are prices high or low on a relative basis? 

With the Bollinger indicator, the two bands (the convention to call these lines "bands" helps distinguish them from the fixed percentage 'envelope' technique) are placed above and below the centered, unseen moving average. The average is usually, but not always, set to a "default" setting of 20 by the charting software. If not, you can change to a 'length' setting of 20. 

Bollinger states: "Two important tools are derived from the indicator: 1.) BandWidth, a relative measure of the width of the bands, and 2.) percent b (%b), a measure of where the last price is in relation to the bands." 

BandWidth = (Upper Bollinger Band - Lower Bollinger Band) / (divided by) the Middle Bollinger Band; percent b = (Last - Lower Bollinger Band) / (Upper Bollinger Band - Lower Bollinger Band) 

BandWidth is most often used to quantify something called "The Squeeze", a volatility-based trading opportunity. Percent(%)b is used to clarify trading patterns and as an input for trading systems. 

What this means is that when the distance between the bands substantially narrows in from a usual pattern with a stock or index, look for signs of a break out move, above or below the recent narrow trading range. 

Good examples of such "Squeeze" opportunities were seen in the SPX chart in late-Sept/early-Oct 2004(upside reversal ahead) and again by late-Feb/early-March 2005 (downside reversal ahead). It could also be noted that the narrowing 'squeeze' in the Bolli Bands first occurred in December '04 and a downside break also followed, but the decline after early-March led to a more prolonged and deeper decline. However, both instances preceded great index option trading opportunities. 

With the addition of the 20-day moving average to the same SPX daily chart below, you can see that the upper and lower lines do not track at equal distances above or below the centered moving average. Rather, when there are more wide-swinging fluctuations above and below the 20-day moving average, the bands widen out. With more a steady price move in one direction, the bands narrow in; i.e., there's less volatility. 

This is the nature of how lines that are plotted two 'standard deviations' above and below an average like this would operate. 

"Standard deviation" describes how prices are arrayed around an "average" value. One standard deviation is a set of values that contains close to 70% of the price fluctuations that occur above and below the moving average used in the Bollinger band 
calculation. 95% of the fluctuations will occur within two standard deviations of the moving average in question. 

Since each Bollinger bands is placed at a fluctuating line that is equal to two standard deviations, 95 percent of all price action will theoretically occur within the upper and lower lines. Each band represents therefore, implied support or resistance. Price swings are unlikely to be sustained above or below these lines for long.

Because of how they are constructed, Bolli bands expand or contract in order to reflect market volatility or the degree of movement in the price swings occurring at any given time. 

If the bands are relatively narrow, the market is experiencing lower price volatility or narrower price swings and the lines will intersect at upper and lower points that will tend to mark the extremes (highs and lows) for these quieter market conditions. 

If prices are experiencing wide-ranging price movement, the bands expand to reflect the higher volatility that exists. If the bands are wide and you can usually quickly see this visually in the pattern of price activity, the market is experiencing higher volatility the lines then suggest where an extreme will be reached based on a more volatile and stronger recent price trend. 

As with envelope lines, they can be used on everything from intraday to daily to weekly charts, although I find that the most common use seems to be with daily charts. 

BOLLINGER BANDS CAN SUGGEST MANY THINGS: 

CHART PATTERN IDENTIFICATION
John Bollinger cited an increasing use of his indicator in helping to spot or clarify chart patterns. For example, a Head & Shoulder's (H&S) top or bottom has a typical Bollinger Band "signature", or a pattern for the Bands that is similar, but slightly different than the actual H&S price pattern.

The use of Bollinger bands in helping better define a chart pattern can be seen in a stock chart [Qualcomm: QCOM] from 2000-2001 and used in my book (Essential Technical Analysis). Here the Bolli Bands made a good outline or "definition" of something that really looked like the outline of a Head and two peaks that looked even more like "shoulders" although the right one has a bit of a spike to it. 

There was especially good definition of the Head; more so than just the price pattern alone. Use of Bollinger Bands here helped highlight an excellent opportunity in puts. 

SOME OTHER NOTES ON BB USES
By definition, prices are "high" (on a relative basis) at the upper band and "low" at the lower band. Armed with this information, you can compare price action to the action of the BB indicator to help you arrive at trading decisions. 

1. As with moving average envelops, prices can and do "walk" up or down the Bollinger Bands. 

2. The moving average used was designed to best detect the "intermediate" trend; e.g., 2-3 weeks or longer. 

3. Unlike moving average envelopes, at least the way I use them, closes above or below the Bollinger Bands can suggest "continuation" signals for the trend rather than "reversal" type indications. 

With the line (close-only) chart of the Nasdaq 100 (NDX) below, there are a few instances shown by the (yellow) circled price action, where closes above or below the BB suggested a continuation of the trend was likely; # 1, 2 and 4. Instance #3 preceded a bottom in NDX. All instances of closes outside the Bolli Bands were significant: 3 as 'continuation' patterns, one as a reversal (#3), occurring before the double bottom. 

4. If the (centered) moving average is lengthened, the number of standard deviations needs to be increased; e.g., 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; e.g., from 2 at 20 periods to 1.9 at 10 periods.

5. The moving average used is a "simple" moving average because a simple moving average is used in the standard deviation process, so the same type of average is logically consistent. 

6. A "touch" to the upper or lower line is just that - a tag or touch. These are not, in and of themselves, a buy or sell 
"signal".

I'm going to do book-end Trader's Corner articles and go into the use that can be made of "straight" moving average percent envelopes in my next Trader's Corner next Wednesday. 

By way of visual contrast to leave you with, this last S&P 500 chart (SPX) chart below shows a centered 21-day moving average with upper and lower envelope lines that represent a value each day equal to 2 percent above and below the 21-day moving average for each close.

You'll note that almost all trading during the period shown occurred WITHIN values that were 2% above/below the 21-day average, with a couple of circled exceptions. 

When prices shot up in early-November, SPX rallied to above the upper trading 'envelope', suggesting rally strength. And, after a prolonged decline into April, SPX fell under the lower (2%) envelope line, which turned out to be predictive for an 'exhaustion' of the decline and an upside reversal to come. 

But, as I said, a more detailed look at the moving average envelope indicator next time. 

Until, then ... 

Good Trading Success! 

NOTE - 
Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Contact Support with 'Leigh Stevens' in the Subject line. 
 

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