by Chris Verhaegh

Bollinger Bands consist of upper and lower envelopes that surround the stock price on a chart.  They are generally plotted as two standard deviations away from a 20 period simple moving average.  This is the primary difference between Bollinger Bands and envelopes.  Envelopes are plotted a fixed percentage above and below a moving average.  Bollinger Bands adjust themselves to current market conditions, because standard deviation is a measure of volatility.  They widen during volatile markets and contract during the less volatile periods.

It is very important that the settings used are two standard deviations and 20 periods.  Bollinger Bands are a math based indicator and any other setting will take away the advantage that comes from using a Bollinger Band correctly.

In a simplified nutshell, two standard deviations should contain roughly 95% of a data set.  The remaining 5% or so should not be part of this containment.  Since the smallest number of data points that can be measured with one as its rarity is 20, these are the numbers chosen as the Bollinger Band settings.

Basically, nineteen out of twenty points should be inside the band, one out of twenty outside.  This one of twenty is the rarity that we are looking for.  Study of Bollinger Bands will clearly show, over and over again, there are not 19 continuous points inside, to every one out.  It’s the law of large numbers that keeps the Band honest.  Have 20,000 points and you should have 19,000 in and 1,000 out.  That’s the beauty of it.

Since our strategy is to look for rare occurrences and trade them, we look for a band that hasn’t had a breakout in a while.  It becomes due.  Like water pressure building in a geyser, Old Faithful will erupt.  We want to be there collecting the profits by bucket loads, if not by truck loads.

Sharp moves in price tend to occur after the bands tighten; the closer to the average the better.  Since reduced volatility denotes a period of consolidation, the first increase in volatility after a consolidation period, tends to mark the start of the next move.

Since the bands measure volatility and large moves come from small volatility, look for the bands to tighten as a great setup.  The implications of volatility studies show, volatility goes through periods of low volatility, followed by high volatility, followed by low and so on.  Since it is easier to recognize low volatility than high (high can get higher easier than low can get lower), tightening bands are a precursor to widening bands.  The move needed to widen Bollinger Bands often allows stock trades with tremendous potential.  Add the leverage inherent in options and you have the potential for astronomical trading profits.

Be aware, moves that don’t break out will often swing to the other side as the bands act like a range oscillator, swinging backward and forward like a pendulum between two points.  This can be tradable information, although it generally doesn’t give the extra kick we are looking for.

As a mathematician, and the son of a carpenter, I appreciate this indicator the most.  Visualize the Carpenter’s Level.  If everything is plumb, the bubble is situated between the lines.  If something is out of kilter, the bubble crosses one line or the other.  Bollinger Bands act like this tool.  We look for the rare event.  We look for the price to be outside the lines.  But more important, we have a formula to anticipate when it might breakout.