Bollinger bands are volatility-based envelopes on either side of a moving average which highlight when a price movement is excessive relative to prior volatility. The envelopes are plotted at a standard deviation above or below a moving average, typically a simple moving average although averages such as exponential moving averages can be used as well. As the distance between the moving average and bands is based on standard deviations, the bands dynamically adjust to changes in volatility.
Bollinger bands use two sets of parameters, the lookback period and standard deviations. Typically, 20 is used for the lookback period, whether on hourly, daily, weekly or monthly timeframes and 2 standard deviations are used although all parameters can be customised based on individual preferences. Typically, the bands contain 90% of all price action, with moves above or below considered significant. However, it is important that moves outside the bands are not considered bullish or bearish on their own, rather representing significant strength or weakness.
The bands help to determine whether prices are overbought or oversold on a relative basis. From a swing trading perspective when the price moves above or below the bands price is considered overbought or oversold and therefore highly susceptible to a near-term correction.
The chart below of the ASX All Ordinaries index highlights moves below the lower Bollinger band on a daily basis. This suggested the price had become oversold in the near-term, a potential buying opportunity, and susceptible to a correction higher which subsequently followed.
Conversely the following chart of the ASX All Ordinaries highlights where the price has moved above the upper Bollinger band on the daily basis. This suggested the price had become overbought in the near-term, potential exit or shorting opportunities, and was susceptible to a correction lower which subsequently followed.
Volatility itself tends to be mean reverting, that is periods of high volatility after often followed by periods of low volatility and vice versa. Bollinger bands are useful in helping to identify these periods, by examining the current width of the bands relative to the historical width, measured as a percentage. The chart below shows the current width of the Bollinger bands as a percentage of the historical width over the past 100 periods. In early March 2020 the bands widen to the highest levels over the past 100 periods represented by a reading of 100. This heightened period of volatility is then followed by a contraction over the next four months, culminating in July 2020 with a reading of zero. This contract period is then followed once again by expanding volatility in throughout September to November 2020.
With moves above or below the Bollinger bands signalling the strength of a price move, this can also signal the start of a trend, particularly when it follows a period of contracting volatility known as a Bollinger band squeeze. The chart below highlights the ASX All Ordinaries breaking below the lower Bollinger band in late February 2020, coupled with expanding volatility in the relative width of the bands following a period of contraction. The close below the lower band signals the strength of the move, coupled with expanding volatility which subsequently turns into a large downtrend through to the end of March 2020.
