What Traders Needs to Know About Bollinger Bands

The S&P 500 Index (SPX) just closed outside of its Bollinger Bands, prompting Senior  Quantitative Analyst Rocky White to dig into what this could mean for the stock market. Below, let's dive deeper into this popular technical analysis tool and learn how it can maximize profits.

What are Bollinger Bands?

Bollinger Bands consist of a simple moving average with two volatility bands that are placed above and below the moving average, based on two times the standard deviation of the price. In practice, normally the wider the bands are, the more volatile recent price action has been, while the tighter the bands are, the lower the recent volatility has been. 

There are a lot of signals different traders utilize with this indicator, but there are three especially popular ones: when an equity's price goes above the upper band, a trader will often view that equity as being "overbought"; when the price goes below the lower band, a trader will often view that as being "oversold"; when the bands contract, and become very narrow, some traders use that as a signal that volatility may soon increase.

Traders also use Bollinger Bands as a signal to determine a period of potential volatility expansion. By nature, volatility is mean-reverting, so an extended period of low volatility will typically be met with volatility expansion, and vice-versa.

What indicators to use in conjunction with Bollinger Bands?

There are many derivative indicators that people use to create signals from Bollinger Bands. One popular indicators is called the bandwidth Indicator. It basically measures the width of the Bollinger Bands relative to the middle band. The calculation is simply the difference between the upper and lower band divided by the moving average. When the percentage becomes very low, traders may look for trades that profit from an increase in volatility. When the percentage becomes very high, traders may look for trades that profit from contracting volatility.

Traders also overlay Bollinger Bands' width with historical readings that have proven significant in the past. For example, a stock/ETF with a Bollinger Band width at or near an annual low (on a daily chart) is typically a good indicator that something is about to happen to cause that stock to move violently. Often times, you’ll get Bollinger Band "pinches" ahead of an event like earnings, Federal Reserve meetings, etc. 

What are the advantages of using Bollinger Bands?

There are two main advantages to using Bollinger Bands. First, they can be visually intuitive to investors and aid them to find situations where the are s are coming together, or almost pinching, which could be an optimal time to get ready for the stock to enter an expansionary phase.

Another advantage is that scans can be easily created among the different platforms available to traders out there. Bollinger Bands make it relatively easy to find situations where stocks are experiencing contractionary phases, which may signal the security is ready to transition to an expansionary phase.

In other words, it is an unbiased tool that allows the investor to visualize where price is at relative to volatility. It also offers triggers for trades that may give the trader tools that are more mechanical when making buy/sell decisions.

When should a trader not use Bollinger Bands?

Traders should shut off Bollinger Bands on trending stocks. There is little to no use for Bollinger Bands when stocks are in strong trending phases.

There are times when a security can stay overbought or oversold for extended periods of time. That is why it is important to utilize other, different factors and different indicators to analyze a stock in combination with Bollinger Bands. In addition, investors may have to adjust the buy/sell signals from the indicator depending on the stock's past signals. As with any indicator, it is always good to back-test and make any adjustments based on the security you are analyzing and its behavior.

The big caveat when using Bollinger Bands is you must always check the news surrounding a security before entering a trade based on a Bollinger Band contraction. Stocks that are involved in mergers and acquisitions will often just churn sideways until the deal is complete, so there’s no real opportunity in those as a trader. Bollinger Bands must always be used within the context of the stock/ETF entering a period of volatility contraction that is a result of normal market forces, and not news that is waiting for a resolution.

How do Bollinger Bands work within Schaeffer's contrarian strategies?

Bollinger Bands are just one of the several technical indicators that can work with our contrarian strategies, since Schaeffer’s Expectational Analysis is made up of three components: fundamental, technical, and sentiment analysis.

This indicator would fall into the "technical" category, and  can be used as a timing tool for the entry and exit of trades. For example, a security may be surrounded by extreme pessimism, but has strong and/or improving fundamentals, and is in the midst of a long-term uptrend. In the short term, a trader may see an oversold signal for the stock and use it as a timing tool to initiate a bullish position that fits the other criteria of the methodology.

Any recent examples of successfully using a Bollinger Band?

Bollinger Bands are the first technical indicator we look for when trying to find straddle trades, so many of our big winners in the Volatility Trader and Weekly Volatility Trader services are good examples.