When John Bollinger developed the indicator that currently bears his name, his intent was to use statistics to identify the extreme ranges of trading. The tool known as Bollinger Bands does an excellent job at determining the relative position of a price when comparing it to recent previous price action. Many traders find that it has reduced value as a prediction tool, but as a preparation tool it is excellent.
With this in mind I want to demonstrate a new way to use the Bollinger bands. It is a bit unusual, but if you use Bollinger bands in this way it can help you determine whether a price is inexpensive compared to recent prices. In effect, you will have a gauge for how to, statistically speaking, buy low.
Normal Band Measures
Bollinger Bands are a good tool for assessing performance of a stock in relation to how volatile the price is currently trading. This indicator, which is overlaid on top of a price chart, consists of three separate bands: a Simple Moving Average in the center, along with lines placed at two standard deviations from the center on either side. The two-standard-deviation width is the default setting for a charting platform, but on many charting platforms, this is easily modifiable.
Together, these bands show the range in which the price is most likely to fluctuate. It’s easy to assess volatility using this indicator—if the price is more volatile the upper and lower bands are further apart, and if the price is more stable the upper and lower bands are closer together (see figure 1).
Standard Bollinger Band applied to VIX – chart courtesy freestockcharts.com
The chart above shows how you can use Bollinger Bands to measure the volatility of the Volatility Index ($VIX). Notice how the bands are wide as the VIX rises during the high-volatility trading in late summer 2011(left portion of the figure). Notice further how later in February (right portion of the figure) the bands narrowed when the market moved with less volatility and the VIX fell. The bands also work with any chart, not just the $VIX.
But Why Be Normal?
Traditionally, the advantage of Bollinger Bands is that they can indicate when a significant price change is occurring. Most traders infer that if a security’s price goes above or below the bands, that’s a sign that the stock is either overbought or oversold respectively, and may soon make a reversal toward the average. But once you understand that this is how the indicators work, you realize there is another way to use this indicator.
Consider that if you were to set the indicators to span over three days (instead of the default twenty), and to measure 1.25 standard deviations (instead of the default two), what you would get would be a zone that measures 75% of normal trading (see figure 2).
Using Bollinger Bands to define “normal” prices. – chart courtesy freestockcharts.com
Using Bollinger Bands in this way will allow you to define what is normal, and what is relatively low or high, based on current volatility. For example, if you were to buy when prices dipped below the range of the bands in January or February as the market trended up, you got some of the best pricing possible—you bought low!
Meanwhile if you sold while prices were down trending in May, prices above the bands were among the highest you could get relative to the time you might have been trading. In other words, you could sell high. This simple strategy gives traders the ability to perform short term trades at optimal price action. As with any indicator, this should only be a part of a larger and more effective strategy for individual trading.