Stock Trading: Using Bollinger Bands to
Spot Potentially Big Moves

by John Forman

Bollinger Bands are one of the more widely known and used technical indicators around.  Most charting packages, even the most basic, have them built in.  The Bands are a volatility-based indicator which apply the statistical measure Standard Deviation to provide a guide as to how a given market or instrument is trading.  There are a great many ways Bollinger Bands can be employed in market analysis, but this article focuses on how one can apply them to the identification of markets ready to make a significant directional move.

The process of finding markets ready to move using Bollinger Bands starts with evaluating the width of the Bands, the area between the upper Band and the lower Band.  We can do this visually by just looking at the charts, such as the example below of daily AAPL.

Notice how the Bollinger Bands go through periods during with they are wide apart and others where they are quite close together.  This, of course, is due to changes in volatility as measured by the Standard Deviation used in the calculation of the upper and lower Bands. 

Recall that the upper Band is determined by taking the Standard Deviation, multiplying it by two, and adding that to the 20-period moving average, which is the middle Band (assuming the use of the common default settings).  Similarly, the lower Band is calculated by subtracting two Standard Deviations from the moving average.

When the closing prices varies widely from the moving average (the middle Band), the Standard Deviation will be high and thus the Bands will be widely spaced.  The reverse is true when prices have been confined to a relatively narrow range around the average.  It is fairly easy to see on the chart how the Bands react to violent market moves as opposed to consolidations.

Band Width Indictor
Our eyes cannot do a really good job at properly evaluating the width of the Bands, though.  This is best done using the Band Width Indicator (BWI), which is calculated as follows: 

BWI = ( UB - LB ) / MB

Where UB is the Upper Band, LB is the Lower Band, and MB is the Middle Band.

Using the common default setting of 20-periods, that means the MB is the 20-period moving average. That default will be the one used in the examples provided herein, though it is by no means necessarily the best option.

The formula above will express the width between the Bands as a percentage of the moving average being used. It could be multiplied through by 100 to provide an integer value (as done on the sample charts). The average (MB) is used rather than current price because it is the central point in the Bands, whereas price could be anywhere within (or even outside) them.

The reason for calculating BWI is that it gives us a normalized reading of how wide the Bands are for comparative purposes. A 100 point band width on the S&P 500, for example, is relatively different when the index is at 900 than when it's at 1500. The chart below provides an example. It is the same a daily chart of AAPL as shown above, but with a BWI plot drawn in.

By looking at the BWI line, not only can we get a quick view of whether the Bands are widening or narrowing, but also how wide or narrow they are on an historical basis.  That is where BWI is its most valuable.

Picking Out "Trend-Ready" Markets
In the chart above, we can see that BWI ranged from a low of about 7% on the bottom end to a high of a little over 30% on the upper end over the last seven months or so.  The low was put in right around the turn of the year at a time when AAPL had been consolidating for the better part of a month.  Shortly there after, the volatility expanded rapidly as the market jumped better than 10 points in a matter of days.

If we look a little further back in time on the chart, to early October, we can see the second lowest BWI reading which came after another period of mainly sideways action.  In that instance, the move which followed was not nearly as explosive as the one in January.  It was, however, a much more gradual move, but nearly twice as big.

Those are the two ways low BWI readings tend to get resolved - either with violent short-term action, or long lasting trends.  As kind of a general rule of thumb, the longer a market has been narrowly traded, thus creating a very low BWI reading, the more likely the ensuing resolution is going to be of the explosive kind.  This is not a hard and fast thing, though.  Some markets are not prone to violence, while others are.  It's  question of knowing your market so you can anticipate what will happen under low BWI circumstances.

Lest you start thinking that narrow Bollinger Bands and low BWI readings mean market breaks to the upside, take a look at the following chart of AAPL from a bit further back in history.

The chart above is actually a weekly graph, which goes to show that BWI is not restricted to being used only on daily charts.  In this case we can observe two low BWI readings.  The first was in June of 2002 right before AAPL took a sharp drop from the middle 20s to the middle teens.  A little less than a year latter the situation was reversed.  BWI got very low once more, but this time the market broke higher.  That move ended up being a longer one in duration, though it covered about the same amount of price ground.

Looking for the Turn
When reviewing BWI, however, it is generally not enough to just look for low readings. In most cases, you need to find a situation where the indicator has gotten to a relative extreme, then has begun turning higher. The reason for this is that BWI can stay low for long periods of time in some cases. The trader trying to exploit a low reading in such a circumstance, would find her/himself attempting to play a flat market, which obviously is a different type of trading than trend-hunting.  We can see a perfect example of that in the weekly chart above where BWI was quite flat for months on end before it finally started moving higher.

It should also be noted at this point that using BWI to indicate the end of a trend could find one leaving a considerable amount of money on the table. Consider the example presented below, which is again daily AAPL, this time zoomed in to the long trend up from October in to December of last year.

Had one exited a long position when BWI rolled over in the middle part of November, about 10 points more upside would have been missed, roughly half the whole move that took place. While a declining BWI can sometimes indicate a trend at or near its conclusion, what it is really saying is that price volatility has dropped off. In smooth, persistent trends, this happens quite often as the market just continues to grind in one direction.

Final Thoughts
Naturally, after one finds a market with a low BWI reading, there remains the task of attempting to ascertain which direction the pending move is going to take. That is an entirely different discussion, though. The Bollinger Bands themselves may not provide much help there. One is left to use other directional indications for that task. One thing to keep in mind, however, is that the initial move which gets BWI rising from a low reading may not be the one which eventually turns in to the big move. Be prepared for the fake-out maneuver. It may not always happen, but it does enough to keep traders on their toes.

There could be dozens and dozens of chart examples provide to point out how low BWI readings can indicate "trend-ready" markets. The suggestion at this point, however, is that you take a look at your favorite stock(s) in terms of BWI, and with the tools you use to determine market direction. If you are a trend trader, BWI may help you be a more successful and profitable one.

About the Author
John Forman is author of the new book, The Essentials of Trading.  To celebrate the book's release, a fantastic special promotion featuring $1000s in trading, investing, and wealth management and creation bonuses has been put together.  Take advantage of this offer now.