In the 1980s, John Bollinger introduced a new tool for technical analysis of stock prices, the Bollinger bands. In 2002, he provided a comprehensive explanation of his technique in his book “Bollinger on Bollinger bands” (McGraw-Hill Books). Their name came when Bollinger appeared on the Financial News Network as he explained his technique for evaluating volatility.
As part of Bollinger’s belief in rational analysis, he was always more interested in the overlap of fundamentals and technical analysis. He used these bands to plot standard deviations above and below a simple moving average. A standard deviation helps measure the volatility (that is, price movement) of a stock price over time. (Of course, this mathematical principle, the standard deviation, illustrates how a stock price can vary from its true value.)
The Bollinger bands act to adjust to market volatility. For example, when the market is volatile, the bands expand away from the moving average, and when things stabilize, the bands contract.
How do traders user the Bollinger bands?
Traders use the Bollinger bands in a number of ways to analyze a share price. If there is a tightening of the bands, many believe that volatility is likely to increase sharply. If a stock price moves toward the upper band over time, they believe that the market is overbought, and if the stock moves toward the lower band, then the market is oversold.
Often traders will buy a stock when a share price hit’s the bottom band, and exit from the market when the price hit’s the moving average (around which the bands are shaped). Other traders sell when the stock hit’s the bottom band.
Often these bands and the technical analysis they provide is used as a tool of confirmation. That is, Bollinger bands are used to confirm the data of non-oscillating tools such as a trendline or chart patterns. When these tools confirm similar results, the trader holds a stronger hand.
Do Bollinger bands work?
Many say this technique is effective. Companies such as Forbes have endorsed the technique (albeit with the qualification that stop-loss orders should be employed to prevent disasters). Similarly in a study of the Chinese market, Bollinger bands were found to be effective when used with a contrarian version of the moving-crossover rule. In yet another study, Bollinger bands were found to be an effective technical analysis technique for predicting a yield curve.
As with any statistical technique however, the Bollinger bands must be employed effectively. Also, no single tool can take into account every factor that may affect a share price or the effects of extraneous elements (like world events) on the marketplace. Still, for those who use a variety of measurements to analyze and predict share prices, the Bollinger bands may prove a useful tool in the arsenal of any trader.