Thursday, February 02, 2017

Bollinger Band - Trading on Volatility

This article was written in 2007.

With emerging markets like the Chinese and Indian economies growing at a fast pace and recording high percentage growth year over year, the bullishness has spilled over to the global stock markets with all major indices hitting new highs at the end of 2006. However, it is unlikely that the world indices will continue to scale up without any corrections. A classic example of a worldwide market correction occurred when the Chinese stock market recorded a near 9% drop in a single-day in Feb 2007. This together with the Yen Carry Trade triggered a chain reaction of global stock markets melt-down.  Since then, global markets had a fast recovery with the likes of the STI index touching the 3500 points and the Dow Jones breaking the 13000 points barrier in April 2007. The example of global markets melt-down and fast recovery demonstrate how volatile the stock market can be. The willingness to take a higher risk is heavily linked to the fact that people are better educated and information is easily available with the help of the internet.  Moreover, the one factor in the stock market that has not changed since its establishment is market psychology. The human psychologies of fear, greed and hope remain the main culprits of the high volatility in the stock market. 

Join the Live Event to Learn Trading Using Technical Analysis, Register Now!

The Bollinger Band, developed by John Bollinger, is widely used by traders to trade the market effectively. The Bollinger Band is constructed using 3 lines; the upper Bollinger band, the Simple Moving Average line (SMA) and the lower Bollinger band. The upper and lower Bollinger bands are usually placed at a distance of 2 standard deviations above and below the SMA respectively. Standard deviation is a mathematical term in which the value is proportional to the volatility of the price movement. SMA line is the averaging of the close price over a certain number of days.  Hence, when the stock is trading sideway or the price volatility is low, the upper and lower bands will converge toward the SMA line. On the other hand, the upper and lower bands will begin to widen and move away from the SMA line when there is substantial fluctuation in the stock price. This article will look in the different ways that Bollinger Bands are used. 

Join the Live Event to Learn Trading Using Technical Analysis, Register Now!

The first application of Bollinger Band is its use in providing an indication of support and resistance level. As we expect prices to move in between the upper and lower bands, the upper band acts as a resistance level to more upsides while the lower band acts as a support level to more downsides.  The following shows how the upper and lower bands provide support and resistance to the price movement.

Figure 1: Use of Bollinger Band as Support and Resistance

During the month of January 2007 to April 2007, FerroChina’s stock price was well-resisted by the upper band, refusing to break new grounds. On the other hand, during the price retracements in early March 2007 and late April 2007, FerroChina was able to find good support level at the lower band that prevented the price from diving further.  

The second application of Bollinger Band is in the powerful Bollinger Squeeze which trigger high probability buy and sell signals. The Bollinger Squeeze occurs when a stock protracted to a period of low volatility has the upper and lower bands appearing to be squeezed together. A buy or sell signal is generated when there is a Bollinger breakout from this squeeze of the lower and upper bands. Figure 2 shows the occurrence of the Bollinger Squeeze and the subsequent Bollinger breakout when the upper and lower bands begin to expand suddenly.

Figure 2: Bollinger Squeeze and Subsequent Bullish Breakout

During the period of January 2007 to March 2007, the big gap between the upper and lower bands shows that Hyflux was trading with high volatility. However in Apr 2007, Hyflux started trading sideways and as a result, the upper and lower bands contracted and squeezed together, indicating the occurrence of the Bollinger Squeeze. A Bollinger breakout then happened when both bands suddenly diverged with the price hugging the upper band thereby triggering a bullish signal. The reverse is true for a breakout to the downside. This is illustrated in Figure 3 where a Bollinger Squeeze was formed in April 2007 with the subsequent bearish breakout happening on 23rd of April 2007.

Figure 3: Bollinger Squeeze and Subsequent Bearish Breakout

We can further enhance the Bollinger breakout after the Bollinger Squeeze with another indicator thus increasing the probability of making a trade in the right direction of breakout. One popular indicator that can be used together with the Bollinger Squeeze is the Relative Strength Index (RSI) which was developed by J. Welles Wilder. The RSI is a powerful indicator used to measure the velocity of the price movements and the values are calculated based on the number of days that the price closes up and the number of days that the price closes down over a certain period of time. In this article, the period of time used is 14 days which is originally proposed by Wilder. Let us re-visit the earlier chart (Figure 2) which featured Hyflux where a buy signal was generated by Bollinger Squeeze on the 25th Apr 2007. An analysis of the RSI indicator shows that the RSI was well supported during the Bollinger Squeeze and was trending upwards as the price approaches Bollinger breakout. This signifies that the price action remain firm throughout the Bollinger Squeeze and it grew in strength as breakout came beckoning. Figure 4 shows the chart of Hyflux using RSI indicator in conjunction with Bollinger Band.

Figure 4: Usage of Bollinger Squeeze with the RSI indicator

The above scenario of combining RSI and Bollinger Band in our analysis can be easily captured by using an automated software program which could save a significant amount of time from looking for these opportunities. One such software is ChartNexus XPertTrader ( that can be used to automatically screen the whole market for stocks that have Bollinger Squeeze together with the RSI trending higher. 

This article has highlighted the importance of understanding the volatility of the stock market in order to make profitable trades. A powerful indicator such as Bollinger Band is widely used to identify buy and sell signals based on two applications. The first involves using the bands as support and resistance with the second involving looking for a Bollinger Squeeze followed by a Bollinger breakout.. Combining Bollinger band with the RSI indicator also increases significantly the probability of the signal being valid.

This article first appeared in Smart Investor in 2007. 
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.