I wrote my last Trader's Corner column on the Moving Average Envelope indicator and its effective use in trading. This indicator is one that I often look at with the major stock market indexes. My article on moving average envelopes is dated 8/27/10 and can be found via the Trader's Corner tab on the Option Investor.com home page or can be perused by clicking HERE.

The other popular type of trading band technical study is the Bollinger Band indicator.

Before I get into this topic I'll bring you up to date on some aspects of the market through today as it relates to the moving average envelope settings I was using as shown in my last Index Wrap article (9/11). I'll use the S&P 500 (SPX) index for my first 3 charts.

I use a 21-day moving average as the centered moving average that then has upper and lower envelope lines that reflect a percentage value above and below this (center) moving average. My starting point for the indexes are values for the envelope lines of 3% above and below the moving average. In a bearish period, the lower envelope line that 'contains' most intraday trading might EXPAND to 4 or 5 percent; the same expansion is seen in strong uptrends. Earlier this month I was using 5% as the lower SPX envelope line, but since the market has been in a strong rally phase in September, I reduced the lower envelope line to 4 percent, which 'touched' the last lows. This is appropriate to my thinking that declines ahead won't be as severe.

Since there is the possibility that SPX will ALSO expand its upper price range in terms of the 3% upper envelope line (given the recent strong uptrend), I have also expanded the upper envelope line to 4 percent as seen in my second chart.

When the trend shifts to up, what we tend to see is that the next high will at least equal the last low in terms of a percentage value above the center moving average. The upper envelope line in my next chart, now reset to 4%, intersects tomorrow at 1134. This is not to say that highs won't pop up above this line, only that the probabilities grow exponentially for a (downside) correction the longer that prices are above this line. We saw this dynamic on the last 3 dips BELOW the lower envelope line. It was a matter of 1-4 days at or below this line before prices rebounded.

BOLLINGER BANDS

I don’t make as much use of this variation of trading bands as I do for simple moving average envelopes, but I do look at them for the unique information they provide. Fellow technician John Bollinger invented the indicator that bears his name as Bollinger bands. My reservations about their use is that it is hard to pinpoint a specific buying or selling area, as these bands expand or contract according to market volatility. This is both, I suppose, the technique’s strength and weakness.

Bollinger Bands (BB) combine a centered simple moving average, which is part of the indicator but is usually NOT shown and I don't on my next chart. The moving average length that John used is 20-days. BB basically combine this moving average indicator with a measurement of current and recent price volatility to determine the optimal placement of the upper and lower lines.

The PURPOSE of the BB indicator is basically the same as moving average envelopes: Are prices high or low on a relative basis? Just as with (moving average) envelopes, two bands (the convention is to call these lines 'bands' to distinguish them from the fixed percentage envelope line technique) are placed above and below to a 20-day (centered) moving average, which in this case is set or 'defaults' to 20-days. However, unlike lines that are a FIXED percent above or below the moving average, Bollinger bands are plotted TWO standard deviations above and below the moving average as is the case of my next chart, also of SPX for comparison.

I find the best use of Bollinger Bands is to apply them to individual stock charts, as you'll see from my next charts taken from my (Essential Technical Analysis) book, so reflect historical chart examples.

One stock (INTC) was in a stable trend and another (QCOM), in the following chart that shows a more volatile period of wide-ranging price swings. In the former, the bands are of a relatively narrow width and in the later, significantly wider apart, at least during a top-building process.

Bollinger Bands example in a more 'stable' (narrow range) trend:

Bollinger Bands in a more wide-ranging (volatile) trend:

Standard deviation of course 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 and this value is what is used in Boli Bands.

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

Because of how they are constructed, Bollinger bands expand or contract in order to adjust to market volatility or the degree of movement in the price swings that are developing at any given time.

If prices are fluctuating in a relatively narrow price range, this is a situation of low (price) volatility as seen by the bands being closer apart. The lined in these market conditions 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. Again however, the lines suggest where an extreme will be reached based on a more volatile recent price trend.

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

MORE IDEAS: FROM A TALK BY JOHN BOLLINGER:

John spoke at the Market Technicians Association (MTA) some years back, when both the MTA offices and my office were in the World Trade (north) Tower. I had some other informal contacts with John during the 90's, such as when we worked together on a project for Dow Jones Telerate. John's talk at the MTA, which we both belonged to, had as its theme, the diversity of people's use of his indicator. For example:

MARKETS: Boli bands are being used in all markets, ranging from stocks, index options, index futures, commodities, currencies, etc.

TIME FRAMES: Ranging from years, quarters, months, weeks, days, hours, minutes and with tick charts.

DIVERSITY: The Bollinger Band indicator is being used to detect the beginning and end of trends, to highlight the potential for reversals, to assess continuation patterns, to identify overbought/oversold conditions and to place stops. Obviously, an effective placement of a stop might be above or below the upper or lower Bollinger band.

CHART PATTERN IDENTIFICATION: John cited an increasing use of his indicator in helping spot or clarify chart patterns. For example, a Head & Shoulder's top as seen above with QCOM, has a typical Bollinger Band 'signature', or a pattern for the Bands that is similar, but slightly different than the actual H&S Top pattern.

In my last chart above, the Head & Shoulder's top pattern had an even better 'definition' of something that looked like and a Head and two peaks that looked more like 'shoulders'; well, the right shoulder has a bit of a 'spike', but there was especially good definition of the Head.

HOW CAN BOLLINGER BANDS DO SO MANY THINGS?

For one thing, they are a 'tool', not a system. Tools, as is well known, can be employed in different ways and the ability to use them skillfully varies quite a bit; e.g., my use of woodworking tools will not produce finished cabinets, but my brother can do that with the same tools.

For another thing, Bollinger bands are highly adaptive as it is volatility that drives the width of the bands. This means that they can be deployed successfully in many different types or phases of markets. As an interest in volatility has grown, using Boli bands is an easy way to include volatility in the trading decision process.

NOT WELL KNOWN: John's defaults were derived from studies of US stocks using daily data over a period of many years. The default length for the moving average is 20 periods or bars. The default for the bandwidth is two standard deviations. John makes greatest use of the Bands on daily or weekly charts. Sometimes he uses them on hourly charts for trade execution, or on monthly charts to gain a long-term perspective.

BEST USE: 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. If prices are high and the indicator confirms this by the fact that the upper band is touching current levels, you have a confirmed high. If prices seem 'high' to you but the BB indicator fails to confirm this, you have an unconfirmed high, which is suggesting that the stock or index has more 'room' on the upside. John indicated that THIS use or purpose was the goal he had in mind when he developed his trading tool.

KEEP IN MIND:

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

2. The 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 be continuation signals rather than reversal type signals.

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. As 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 itself, a buy or sell signal.


GOOD TRADING SUCCESS!