We are creatures of emotion, creatures bristling with prejudices and motivated by pride and vanity. As creatures of emotion, we crave predictability and order. We struggle to find patterns in its absence. As today is the first day of the remainder of our lives, so you and I, being a participant of stock market , should take it seriously. Go on reading, you will be able to relate it soon. Yes, there is a term called volatility which is inseparably interrelated to financial market.
If you and I could do that, by now we would have been in the list of top five richest persons of the world. Median and expected do not mean the same thing at all in the financial world. The terms bullish and bearish are often hollow words with no application in a world of randomness — particularly if such a world, like ours, present asymmetric outcomes. Is it reasonable to take that volatility as a constant over time?
It is widely accepted today that an assumption of a constant volatility fails to explain the existence of the volatility smile as well as the leptokurtic character fat tails of the stock distribution.
You must be knowing that the sharpest of all sharp brains are involved in this stock market with different mathematical models and statistical tools to quantify volatility and estimating the underlying price. It is beyond the scope of this article to articulate those complex structures in words. These bands are volatility indicator similar to the Keltner Channel. Except that Bollinger Bands are placed two standard deviations above and below the moving average which is usually 20 days.
To know more on Keltner Channel click here. It evolved from the concept of trading bands. Two trading bands are placed around a moving average similar to the envelope technique. For your simplicity I am breaking it down: The values for N and K are 20 and 2.
Normally Simple Moving Average is preferred to Exponential Moving Average because it is used in calculating the volatility used to set the bandwidth, hence, it is internally consistent to use the same average to set the centre point.
Moreover, for both the middle band and calculation of standard deviation usually the same period is used. For a 20 day average, the most recent 20 days are used. The same is true for volatility; for each period, the volatility is measured using the immediately preceding periods. You must be knowing that Standard Deviation S. Surprisingly you will find that as you shorten the calculation period, you will need to reduce the number of standard deviations used to set the bandwidth, and that as you lengthen the number of periods, you will need to widen the bandwidth.
According to Bollinger if you use a starting point of 2 standard deviations and a period calculation, you should decrease the bandwidth to 1. But none of the strategies are more important than the evolution of the markets. If the period is less than 10 or greater than 50, changing the periodicity of the bars is more appropriate.
Suppose if you require a shorter calculation period than 10 days, a shift to hourly bars might be better than trying to squeeze the calculation period ever tighter.
I want to add one more variation of Bollinger, i. It can be done in two ways. The other is to plot multiple sets of bands with different parameters, say 20 periods and 2 standard deviations and 50 periods and 2. As a thumb rule, prices are considered to be overextended on the upside overbought when they touch the upper band.
They are considered overextended on the downside oversold when they touch the lower band. The statistical concept behind the technical terms overbought and oversold is that as prices depart from the average, you and I should expect them to move back toward the average.
Bollinger bands are useful to provide a relative definition of high and low. At the upper band prices are high and vice-versa. It helps us in pattern recognition and develop our own strategy. I want to provide another information. Bollinger further developed 3 new indicators based on his own bands. By now you must have got an idea about the use of Bollinger bands. The most common way to use it is keeping the upper and lower bands as price targets. Suppose if prices bounce back from the lower band and cross above the 20 day average, then the upper band becomes the price target on the upside and vice-versa.
Normally the price level oscillates inside the upper band and the 20 day average in case of a strong uptrend, whereas it just the opposite in case of a strong downtrend. During a period of rising price volatility, the distance between the two bands will widen, whereas during a period of low volatility the bands will contract.
Usually the contraction and extraction comes alternately. I will break it down for better clarity. Before proceeding further you should know that volatility is cyclical even when price is not. Please remember these points. During period of low volatility the bands come closer constricting the moving average.
This rule is never broken. When volatility falls to historically low levels, the squeeze is on. Normally the squeeze is triggered when bandwidth drops to its lowest level in six months. Often as the end of a squeeze nears, price will stage a short fake out move, and then abruptly turn and surge in the direction of the emerging trend.
To deal with the head fake, you can wait for the move to develop sufficiently so that there is a little question about the nature of the emerging trend. Or if you want to trade the squeeze right from the beginning you can take an initial position in the direction of the fake and use the trailing stop loss technique. After low volatility, high volatility comes to the table. Hence, when a powerful trend is born, volatility expands so much that the lower band will turn down in an uptrend and vice-versa.
But you know it works very well when combined with other indicators and oscillators. Usually the maximum life span of the price movement occurs inside the two bands. When the price breaches on either side it is called breakouts. When combined with other factors it can provide some clues.
For simplicity you should consider this point as well. As mentioned earlier that expansion follows contraction and the process is repeated. Hence, when the level of volatility decreases from an expansion phase, it is sometimes known as pinch pattern. As you know that a table looks stable in four legs, sometimes three is okay, but less than that it behaves like a drunken person. Likewise any trade irrespective of trend following, contrarian or swing you should consider at least three conditions to fulfil.
It will not only help you to make better actions but also will gradually get reflected in your portfolio. Bollinger used the concepts of M-patterns in his own bands to spot the M-Top. Among the possible patterns that can form M-Top are double tops, head and shoulders and diamonds. The ideal M-Top is formed when. Step 3 Price level bounces back towards the upper band. Ideally should be lower than the prior high and below the upper band. This tops act as a warning sign.
Moreover, the weakness of the trend is reflected when the second high fails to touch the upper band. The momentum loses its strength and has a possibility to reverse. Considering other factors one can easily go for a contra trade. Just like the M-top, the possible patterns that can form W-Bottom are double bottoms, inverted head and shoulders.
The ideal W-Bottom is formed when. Step 3 Price level is pulled back towards the lower band. Ideally should be higher than the prior low and above the lower band. This bottoms act as a warning sign. Moreover, the weakness of the trend is reflected when the second low fails to touch the lower band. You know along with volume indicators momentum indicators can be very useful in the diagnostic process. As you know that each indicator operates independently of the other, so when they signal together, they afford a high level of confidence in the outlook for the stock.
Some of the concepts mentioned here are the results of my speculation based on the theories of John Bollinger and John Murphy. You must be knowing that cells that fire together, wire together. As an expression of gratitude I would like to thank you for taking the trouble to read up to this sentence. It does not intend to provide any professional advice relating to any situation or content. Nothing is explicitly or implicitly guaranteed with respect to the information provided herein.
I was thinking to buy a book on bollinger band analysis but was doubtful how much I would be able to put it to practical use. Now I am confident that I should definately buy and learn.
Thanks to your easy explanation. I personally wouldnt mind even paying for such service at all! To keep it simple and precise for trading, it would be better to study the Bollinger bands.
BBImpulse — It helps to measure the change in price as a function of the bands. Bandwidth delta — It helps to quantify the changing width of the bands. Volatility and Band Width Yes, band width measures volatility.More...