How to Analyze Volatility with Bollinger Bands - dummies

How to Analyze Volatility with Bollinger Bands

By Joe Duarte

Bollinger bands provide you with another nice visual of relative volatility levels. This technical tool uses a simple moving average (SMA) surrounded by upper and lower bands, both derived from a standard deviation calculation. John Bollinger, the tool’s developer, uses the following as default settings:

  • 20-period SMA

  • Upper band (SMA + two standard deviations)

  • Lower band (SMA – two standard deviations)

The bands contract and expand as price volatility contracts and expands. Two additional Bollinger band tools include the following:

  • Bandwidth (BW) measures the distance between the two bands using the calculation: BW = (Upper BB – Lower BB) / Moving Average.

    According to Bollinger, when BW is at its lowest level in six months, a squeeze candidate is identified. That’s a security that is consolidating before a potentially strong breakout higher or lower. It is not uncommon for a false move to occur, so straddle strategies — where you make both long and short bets simultaneously in order to be prepared for which way the stock breaks — can provide a way to play this situation.

  • %b identifies where the price is relative to the BW, calculated using a variation of George Lane’s Stochastic indicator, with values ranging from

    • 0 to 100 when price is at or between the bands.

    • Less than 0 when below the lower band (bearish).

    • Greater than 100 when above the upper band (bullish).

Look for confirmation from more than one indicator and compare the action in the price charts to what the indicators are predicting. Also review the news to see if known meaningful developments are affecting prices. In a world where conflicts are numerous and escalating on a regular basis, external events could easily affect market as well as individual security prices at any time.

A value of 75 reflects price that is within the bands and one quarter below the lower band from a total bandwidth standpoint. %b normalizes price relative to bandwidth size and allows you to make an apples-to-apples comparison of different stocks for ranking purposes.

Different sectors experience bullish and bearish trends at different times. Although strong rallies and declines in the broad markets often move all securities in the same direction, the strength and duration of the moves for these different securities can vary greatly. In general, the following principles apply:

  • Securities and sectors with very high values for %b are bullish when confirmed by other technical tools and the activity on the price charts.

  • Securities and sectors with very low values for %b are bearish when confirmed by other technical tools and the activity on the price charts.

Bollinger noted that rather than prices being extended when near a Bollinger band, the condition actually reflects strength and a breakout that can continue. Look for pullbacks toward the moving average line to establish new positions in the direction of the trend after such a breakout.