Advanced Bollinger Bands® Techniques – More Variations Than Most Traders Realize
Channel Indicators are some of the oldest indicators still used by technical traders. They were first devised by using simple moving averages, above and below price, to present a “channel of price” for early technical analysts. These were also called “envelopes,” which are not as popular these days.
Bollinger Bands® the channel indicator was written by John Bollinger CFA,CMT and are the trademark of the author. As both a CFA working with quantitative fundamental analysis and a CMT working with technical analysis, John Bollinger transformed the old style, outdated channels and envelopes into a powerful new tool by incorporating a standard deviation into his formula.
Bollinger Bands are popular for good reason. They really help traders who lack good Spatial Pattern Recognition Skills™ to see compression patterns, extreme patterns, and variations of price. They give that extra detail to charts that help beginners and advanced traders with chart-reading difficulties see and understand what price is actually doing. Since Bollinger Bands are able to expand and contract with price action, they are extremely useful in numerous market conditions where price is moving sideways more often than trending up or down.
The Bollinger Band indicator employs two simple moving averages with two standard deviations. By applying the standard deviations to the moving averages, it improves the reliability of the moving average channel impressively. This addition of standard deviation provides that at least 95% of price is enclosed in the channel most of the time. During a consolidation, these bands will define the support or resistance levels in stocks in a graphical manner that makes it easier for beginners to recognize.
Chart example #1 is of the Nasdaq Composite Index (INDEX:COMPQX), and it shows how Bollinger Bands respond to a variety of trend conditions.
On the far left side of the price chart, a Platform market condition compresses prior to the moderate uptrend. This is followed by another sideways pattern with less compression that breaks mildly to the downside in August. Then a Velocity market condition follows, which turns down into a velocity downtrend with a velocity uptrend. The extreme of the “V” is defined by extreme widths on the Bollinger Bands, warning traders that these are well beyond the normal price patterns. The current Trading Range conditions are the least favorable for Bollinger Bands due to the inconsistency of the range.
Bollinger Bands on price is typically how the individual technical trader uses them. However, there are far more uses that professionals and advanced technical traders will want to adopt to enhance their trading skills and increase their profitability to the next level.
What makes Bollinger Bands even more useful for technical traders, especially professionals, is that the band settings are adaptable. This allows for customization to a technical trader’s specific trading style, parameters, and preferences. By being able to customize the Bollinger Bands Standard Deviation settings and periods, the professional can avoid the common risk of “crowd trading” and “cluster order flow.” This makes Bollinger Bands a far more valuable subordinate indicator for most professionals and advanced technical traders.
The settings on the bands should be adjusted also for the specific “hold time” for the intended trading style. For instance, it is common to use a 20-day for Position Trading and 10-day for Swing Trading. Shorter periods can be used for Intraday and Day Trading. It is important to test each setting period before using the bands in live trading.
Few technical traders take full advantage of the numerous ways that this versatile indicator can be used. Most technical traders use Bollinger Bands strictly on the price chart. However, there are considerable advantages to using Bollinger Bands as a subordinate on volume oscillators, such as Time Segmented Volume (TSV) or Money Flow (MF).
Chart example #2 shows how applying the Bollinger Bands to Time Segmented Volume, which is an accumulation/distribution volume oscillator, reveals extreme TSV patterns more easily and the trends of the TSV indicator are also more recognizable. Bollinger Bands can be used with any line indicator to improve the Spatial Pattern Recognition Skills for technical traders.
Chart example #3 of the Starbucks Corporation (NASDAQ:SBUX) shows Money FLow Index (MFI) with Bollinger Bands, which helps technical traders see the extremes of this line indicator more easily.
Chart example #4 is the same SBUX stock chart again but with Bollinger Bands applied to Wilder’s RSI, which again provides far more information than the line indicator by itself. In addition, there are several variations of the Bollinger Bands formula John Bollinger developed later. Bollinger %B and Bollinger Bandwidth are also excellent indicators worth learning.
Bollinger Bandwidth is a version of Bollinger Bands in a histogram layout. The Bandwidth is ideal for technical traders who struggle with candlestick pattern recognition, or those technical traders who prefer not to have their price charts cluttered so they can see the candlestick formations. Experts in candlestick pattern analysis prefer Bollinger Bandwidth, as it keeps the candlesticks clean and visible but provides the easy to recognize compression patterns that signal trend breakout patterns.
Bollinger Bandwidth is very simple to read and interpret, and at times offers a better and faster identification of compression patterns which occur prior to breakout moves both up and down.
In chart #5, SBUX is showing a sudden and tight compression pattern with Bollinger Bandwidth. The compression is so tight it signals the stock is going to breakout soon. Red lines are drawn on the compression area to show how quickly and tightly the price compressed. The Bollinger Bandwidth histogram suddenly dropped to a very low range as this compression started providing early warning of a breakout.
As with all indicators, in order to use the indicator properly with accurate analysis, the limitations of the indicator must be known. This is necessary so that technical traders can adapt, adjust, and modify their chart analysis by adding additional indicators to clarify signals and directional movement. In addition, at times it is best to use an alternative indicator during market conditions where it either fails to function properly or is not reliable.
Bollinger Bands is an excellent indicator for exposing extremes in price action, and compression patterns that form prior to breakouts. However, Bollinger Bands are not a directional breakout indicator. In order to know what direction the stock will take, it is necessary to include Volume Bars, Balance of Power (BOP), or an alternative uptick to downtick Large Lot versus Small Lot formula based indicator to reveal true Dark Pool accumulation or distribution patterns. A Volume oscillator, such as Time Segmented Volume is also extremely useful in determining the direction the price will move, after the compression pattern shown by Bollinger Bands or Bandwidth compression signals.
The indicators that indicate the direction the stock will take out of the sideways pattern must be Volume and Quantity based indicators. Price and Time indicators do not reveal where Dark Pools are buying or selling. These giant funds are the largest investors in the market, and have special orders that allow them to enter the stock without disturbing price.
Bollinger Bands are a subordinate indicator, which means they must be applied to a primary indicator or price. Like all indicators, Bollinger Bands work ideally in certain market conditions which are the following.
- Sideways patterns that are not Trading Range width, which is over 10 points or in excess of 30% range of the price.
They are not ideal for Velocity markets, Moderately Trending with speculative action, or Trading Range market conditions. They also tend to not be as reliable during Topping market conditions. Bollinger Bands can compress at times in tops, but often do not compress sufficiently for a warning.
Bollinger Bands and Bollinger Bandwidth are excellent indicators for technical traders, who need help reading charts and interpreting price action accurately. Both indicators reveal compression patterns, extreme deviation patterns, and other price action that may not be as easy to see on the chart for the beginner, novice, and technical traders who want to improve their Spatial Pattern Recognition Skills.
Bandwidth is a good alternative for technical traders, who prefer to read the candles without cluttering the price with other indicators.
Bollinger Bands can be used on any Primary Indicator, as a subordinate to the Primary Indicator. They work best with Primary Line Indicators. When using Bollinger Bands with a Primary Line Indicator, do not use other subordinates, because this will create too much clutter and confusion when reading the chart.
iTrader technical analysis using a Stockcharts chart, courtesy of Stockcharts.com
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