Well as of today, I no longer use bands in my trading. This is a warning sign.
The Bollinger Bounce
If you were bullish, you had a natural tendency to draw the bands so they presented a bullish picture, if you were bearish the natural result was a picture with a bearish bias. This was clearly a problem. We tried reset rules like lookbacks with some success, but what we really needed was an adaptive mechanism.
I was trading options at the time and had built some volatility models in an early spreadsheet program called SuperCalc. One day I copied a volatility formula down a column of data and noticed that volatility was changing over time.
Seeing that, I wondered if volatility couldn't be used to set the width of trading bands. That idea may seem obvious now, but at the time it was a leap of faith. At that time volatility was thought to be a static quantity, a property of a security, and that if it changed at all, it did so only in a very long-term sense, over the life of a company for example.
Today we know the volatility is a dynamic quantity, indeed very dynamic. After some experimentation I settled on the formulation we know today, an n period moving average with bands drawn above and below at intervals determined by a multiple of standard deviation We use the population calculation for standard deviation. The defaults today are the same as they were 35 years ago, 20 periods for the moving average with the bands set at plus and minus two standard deviations of the same data used for the average.
I had presented a chart showing an unconfirmed tag of my upper band and explained that the first down day would generate a sell signal. Bill then asked me what I called those lines around the price structure, a question that I was totally unprepared for, so I blurted out the alliteratively obvious choice: They are curves drawn in and around the price structure usually consisting of a moving average the middle band , an upper band, and a lower band that answer the question as to whether prices are high or low on a relative basis.
Bollinger Bands work best when the middle band is chosen to reflect the intermediate-term trend, so that trend information is combined with relative price level data. For many years that was the state of the art: Here are a couple of practical examples of the usage of Bollinger Bands and the classic Bollinger Band tools along with a volume indicator, Intraday Intensity:. Click chart to enlarge. Changing the number of periods for the moving average also affects the number of periods used to calculate the standard deviation.
Therefore, only small adjustments are required for the standard deviation multiplier. An increase in the moving average period would automatically increase the number of periods used to calculate the standard deviation and would also warrant an increase in the standard deviation multiplier. Bollinger suggests increasing the standard deviation multiplier to 2. W-Bottoms were part of Arthur Merrill's work that identified 16 patterns with a basic W shape.
In particular, Bollinger looks for W-Bottoms where the second low is lower than the first but holds above the lower band. There are four steps to confirm a W-Bottom with Bollinger Bands. First, a reaction low forms. This low is usually, but not always, below the lower band. Second, there is a bounce towards the middle band. Third, there is a new price low in the security. This low holds above the lower band. The ability to hold above the lower band on the test shows less weakness on the last decline.
Fourth, the pattern is confirmed with a strong move off the second low and a resistance break. First, the stock formed a reaction low in January black arrow and broke below the lower band. Second, there was a bounce back above the middle band. Third, the stock moved below its January low and held above the lower band. Even though the 5-Feb spike low broke the lower band, Bollinger Bands are calculated using closing prices so signals should also be based on closing prices. Fourth, the stock surged with expanding volume in late February and broke above the early February high.
M-Tops were also part of Arthur Merrill's work that identified 16 patterns with a basic M shape. According to Bollinger, tops are usually more complicated and drawn out than bottoms. Double tops, head-and-shoulders patterns, and diamonds represent evolving tops. In its most basic form, an M-Top is similar to a double top. However, the reaction highs are not always equal.
The first high can be higher or lower than the second high. Bollinger suggests looking for signs of non-confirmation when a security is making new highs. This is basically the opposite of the W-Bottom. A non-confirmation occurs with three steps. First, a security creates a reaction high above the upper band.
Second, there is a pullback towards the middle band. Third, prices move above the prior high but fail to reach the upper band. This is a warning sign. The inability of the second reaction high to reach the upper band shows waning momentum, which can foreshadow a trend reversal.
Final confirmation comes with a support break or bearish indicator signal. The stock moved above the upper band in April. To get the most from this service knowledge of Bollinger Bands is highly recommended. Bollinger on Bollinger Bands has been translated into twelve languages and is available worldwide. The English version can be ordered here. To learn more about Bollinger Bands, please watch some of our videos. BB-Stops A profitable trade depends on when the trade is closed.
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