Bollinger on Bollinger Bands by John Bollinger

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  1. Bollinger on Bollinger Bands

Bollinger Bands® are a technical analysis tool, defined by a set of bands plotted relative to a moving average. Developed by John Bollinger in the 1980s, they are used to measure market volatility and to identify potential overbought or oversold conditions. This article provides a comprehensive overview of Bollinger Bands, drawing heavily from John Bollinger's own writings and insights. We will cover the construction of the bands, how to interpret them, common trading signals, and advanced concepts as presented by Bollinger himself.

History and Philosophy

John Bollinger developed Bollinger Bands out of a dissatisfaction with relying solely on price alone. He felt that price data was insufficient without context, particularly regarding volatility. His core idea was to create bands that would *react* to price movements and volatility changes, providing a dynamic representation of the market. He drew inspiration from earlier work on bands and statistical process control, but aimed to create a tool specifically tailored for financial markets. The Bands were first publicly described in his book, *Bollinger on Bollinger Bands*, published in 2001. Bollinger emphasizes that the Bands aren't a system in themselves, but rather a framework for building trading systems. They are best used in conjunction with other Technical Analysis tools.

Construction of Bollinger Bands

Bollinger Bands consist of three lines:

  • Middle Band: This is typically a simple moving average (SMA) of the price. While a 20-period SMA is the most common setting, Bollinger stresses that the optimal period is dependent on the asset and timeframe being analyzed. Other moving averages, like the exponential moving average (EMA), can also be used, but the SMA is often preferred for its simplicity and responsiveness.
  • Upper Band: This is calculated by adding a specified number of standard deviations to the middle band. The standard deviation measures the dispersion of price around the moving average, effectively quantifying volatility. Typically, two standard deviations are used. Formula: *Middle Band + (Standard Deviation x 2)*
  • Lower Band: This is calculated by subtracting the same number of standard deviations from the middle band. Formula: *Middle Band - (Standard Deviation x 2)*

The standard deviation is calculated over the same period as the moving average. For example, if a 20-period SMA is used, a 20-period standard deviation is also used.

The choice of the number of standard deviations is crucial. Two standard deviations encompass approximately 95% of price action under normal market conditions, assuming a normal distribution. Bollinger advocates for experimenting with different standard deviation multipliers (e.g., 1.5, 2.5, 3) to adjust the sensitivity of the bands to price movements and volatility. A higher multiplier creates wider bands, while a lower multiplier creates narrower bands.

Interpreting Bollinger Bands

Interpreting Bollinger Bands is not simply looking for price to touch the bands. Bollinger emphasizes understanding what the bands *tell* you about the market. Here are key interpretations:

  • Volatility Contraction (The Squeeze): When the Bands narrow, it indicates a period of low volatility. Bollinger calls this a "squeeze". Squeezes often precede significant price movements. The direction of the breakout from the squeeze is unknown; it could be upward or downward, therefore confirmation from other indicators is vital. This is a signal of potential energy building up in the market. Trading Strategies should be employed to capitalize on the breakout.
  • Volatility Expansion: When the Bands widen, it indicates increasing volatility. This often occurs during strong price trends.
  • Price Touching the Upper Band: Price touching or briefly exceeding the upper band *does not* automatically mean the asset is overbought. It simply suggests that the price has moved significantly higher and volatility is increasing. In a strong uptrend, price may walk along the upper band. Bollinger cautions against using the Bands as simple overbought/oversold indicators.
  • Price Touching the Lower Band: Similarly, price touching or briefly exceeding the lower band *does not* automatically mean the asset is oversold. It suggests the price has moved significantly lower and volatility is increasing. In a strong downtrend, price may walk along the lower band.
  • W-Bottoms and M-Tops: Bollinger identified specific price patterns formed in relation to the Bands. A "W-Bottom" occurs when price makes a low outside the lower band, pulls back in, and then makes another low outside the lower band, forming a "W" shape. This is often a bullish reversal signal. An "M-Top" is the opposite, occurring during a downtrend and suggesting a potential bearish reversal.
  • BandWidth: This is a derived indicator that measures the distance between the upper and lower bands. It directly reflects the level of volatility. Bollinger uses BandWidth to identify periods of low and high volatility and to confirm squeeze patterns.
  • Bollinger %B: This indicator measures the position of the price relative to the Bands. It is calculated as: *(Price - Lower Band) / (Upper Band - Lower Band)*. A value greater than 1 indicates price is above the upper band, a value less than 0 indicates price is below the lower band, and a value of 0.5 indicates price is at the middle band. This is a normalized oscillator.

Trading Signals and Strategies

Bollinger Bands provide several potential trading signals, but Bollinger stresses that these should be used in conjunction with other Indicators and confirmation.

  • Squeeze Breakout: As mentioned earlier, a squeeze suggests a potential breakout. Traders often look for confirmation signals, such as a price breakout above resistance or below support, accompanied by increasing volume, to confirm the direction of the breakout. Breakout Trading is a common strategy.
  • Walk the Bands: When price consistently touches or walks along the upper band in an uptrend, it suggests strong bullish momentum. Conversely, when price walks along the lower band in a downtrend, it suggests strong bearish momentum. This is not a signal to sell or buy, but rather an indication of the trend's strength.
  • Double Bottom/Top Confirmation: W-Bottoms and M-Tops, when confirmed by volume or other indicators, can provide high-probability reversal signals.
  • Bollinger Band Bounce/Fade: This strategy assumes that price will revert to the mean. Traders look for price to touch the upper band and then fade (move back towards the middle band), or touch the lower band and then bounce (move back towards the middle band). However, Bollinger cautions that this strategy is less reliable in strong trends.
  • Using Bollinger Bands with RSI: Combining Bollinger Bands with the Relative Strength Index (RSI) can enhance trading signals. For example, if price touches the upper band and RSI is above 70, it may suggest an overbought condition. Conversely, if price touches the lower band and RSI is below 30, it may suggest an oversold condition.
  • Bollinger Bands and Volume: Volume confirmation is crucial. Breakouts from squeezes should be accompanied by increased volume. Similarly, reversal patterns should be confirmed by volume spikes. Volume Analysis is essential.

Advanced Concepts & Bollinger's Insights

Bollinger goes beyond the basic interpretation of the Bands. Here are some advanced concepts he emphasizes:

  • Context is King: The interpretation of Bollinger Bands depends heavily on the context of the market. What might be considered overbought in a ranging market could be normal in a strong trend.
  • Understanding Volatility: Bollinger encourages traders to understand the underlying drivers of volatility. News events, economic data releases, and geopolitical factors can all impact volatility and, consequently, the Bands.
  • Multiple Time Frames: Analyzing Bollinger Bands across multiple timeframes can provide a more comprehensive view of the market. For example, a squeeze on a daily chart might be confirmed by a similar squeeze on a weekly chart.
  • Bollinger Bands as a Filter: Bollinger suggests using the Bands as a filter for other trading systems. For example, only take long trades when price is above the middle band, or only take short trades when price is below the middle band.
  • The Importance of Backtesting: Bollinger strongly advocates for backtesting any trading strategy that incorporates Bollinger Bands to determine its profitability and risk characteristics. Backtesting is critical for any strategy.
  • Don't Force the Bands: Avoid looking for signals that aren't there. The Bands should be used as a tool to *confirm* your trading ideas, not to generate them.
  • Bollinger Bands and Options Trading: Bollinger originally developed the bands with options traders in mind. The bands can be used to assess the implied volatility of options and to identify potential arbitrage opportunities.
  • Keltner Channels vs. Bollinger Bands: Bollinger acknowledges the similarity to Keltner Channels but emphasizes that they are different tools. Keltner Channels use Average True Range (ATR) instead of standard deviation, making them more responsive to price gaps and extreme volatility.

Settings and Optimization

While 20-period SMA and 2 standard deviations are common defaults, Bollinger stresses the importance of optimization. Factors to consider include:

  • Asset Class: Different asset classes (stocks, forex, commodities) may require different settings.
  • Timeframe: Shorter timeframes (e.g., 5-minute, 15-minute) require shorter periods, while longer timeframes (e.g., daily, weekly) require longer periods.
  • Market Conditions: During periods of high volatility, wider bands may be more appropriate. During periods of low volatility, narrower bands may be more appropriate.
  • Personal Trading Style: Risk tolerance and trading style will influence the optimal settings.

Experimentation and backtesting are essential to finding the best settings for your specific trading strategy.

Resources and Further Learning

Conclusion

Bollinger Bands are a powerful technical analysis tool when used correctly. John Bollinger's emphasis on understanding volatility, context, and the importance of confirmation is crucial for successful trading. They are not a "holy grail" but a valuable component of a comprehensive trading strategy. Mastering the interpretation of the Bands and incorporating them with other indicators can significantly improve your trading performance. Remember to backtest thoroughly and adjust settings to suit your specific trading needs. Trading Psychology is also key to avoid impulsive decisions based solely on band touches. Risk Management should always be a priority. Finally, understanding Market Structure will help interpret the signals from the Bands more accurately.


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