A technical analysis tool used by professional traders globally, Bollinger Bands are a potent indicator for identifying favorable trading conditions. Originally developed by John Bollinger in the early 1980s, this trading tool can provide significant opportunities to active traders if utilized correctly with quantified strategies and a systematic methodology.
Bollinger Bands identify the price of a trading vehicle in relation to its previous trading history, with two standard deviation bands above and below a simple moving average providing a relative high and low in price. While the period length can be tailored to fit your personal strategy, standard Bollinger Bands are composed of a set moving average with predetermined standard deviation lines above and below the MA. Together, these bands paint a picture of the security’s high and low pricing points and can be incredibly valuable in forming predictions for future short-term movement within those plotted lines.
As the standard deviation bands widen and contract in relation to the moving average, signals for advantageous market movements can be identified and acted upon. Narrowing Bollinger Bands usually forecast the start of new trending movement, and are generally indicative of lower volatility in the vehicle. Likewise when the bands are spread very wide from each other, volatility can be considered at a high point in relation to its average.
On 8/8/11, Walter Investment Management Corporation (WAC) displayed a Bollinger Bands long entry signal at 20.46, and traders who took advantage of this indication could have exited the next day on 8/9/11 at 22.98 for a 12.31% gain.
Similarly on 8/8/11, the Bollinger Bands showed oversold conditions for Sociedad Quimica Chile (SQM), and with an entry level of 51.48 traders could have locked in on an 11.15% gain at the exit signal the following day on 8/9/11 at 57.23.
This measurement of volatility as the Bollinger Bands tighten and spread provides a direct indicator of whether a vehicle is overbought or oversold. As the price edges closer to the bottom band, the security can be considered more and more oversold. When the price nears the top band, the signs point to overbought territory. This valuable indicator can be useful for providing confirmation for a trade, but by no means is a stand-alone indicator of entry or exit levels.
Instead traders can take advantage of the signals of the start or end points of a substantial trend. As volatility skyrockets and the Bollinger Bands become extremely expanded, the two high and low bands can even move in opposition to the trend. When they start to contract again, it’s a clear sign that the current trend is coming to a close and an upcoming reversion can likely be expected.
As an indicator for short-term movement in a security, Bollinger Bands highlight serious opportunities for traders as pricing dips or rises above the standard deviation bands and extreme oversold or overbought conditions are reached. Options traders can equally capitalize on this indicator as well, as they buy or sell with the expectation of reversion back towards average implied volatility points.
In conjunction with a quantified, statistically-backed strategy, Bollinger Bands can provide accurate and consistent signals for successfully trading the markets.
If you’d like to learn more about trading with Bollinger Bands, click here to see how you can start utilizing them in your trading immediately with the new comprehensive trading guidebook: Trading with Bollinger Bands – A Quantified Guide.