Bollinger Bands: The Best Volatility Gauge for the Intraday Trader
Introduction
One of the more common technical tools used by traders, the Bollinger Bands were created by John Bollinger in the early 80s. The tool was not intended as a technical analysis item for trading decisions, but its perceived utility for that purpose has made it widely popular in the ensuing decades. It is likely to be a part of any useful trading software, and is utilized both independently, and also as part of a general trading strategy by countless traders all over the world.
Note: Past performance is not indicative of future results.
Here we see a typical day's price action analyzed with the Bollinger Bands. We observe the contraction of the bands in the middle part of the chart, and on the left- hand side. In between, we observe the bands expanding as the violent up- and downward movements create great momentum in the market. The upper and lower lines are the standard deviations to be discussed below soon, while the middle line is the moving average often used as the signal line by traders.
Calculation of the Bands
The Bollinger Band consists of a moving average, and two standard deviation indicators superimposed on it. The standard deviation is used to determine how much the price diverges from the mean (i.e. how great the momentum is) for the ongoing market movement. Interested readers can refer to the related article on this website, but typically, the standard deviation will move away from the moving average in the middle when the price moves up or down with strong momentum.
More concisely, the Bands consist of
an N-period SMA, EMA, or smoothed moving average in the middle, depending on the choice
the upper Bollinger Band, which is an N-period standard deviation multiplied with a factor K, and added to the SMA value
the lower Bolliner Band, which is the same, but the standard deviation is subtracted from the SMA.
N and K can be determined by the trader. Typical values are 20 for N (the SMA and standard deviation period), and 2 for K. The K factor is used to make bands pronounced and easily observed.
Trading with the Bollinger Bands
There are many different ways of interpreting the bands. At its simplest form, (and also as advocated by its creator, Professor Bollinger) the bands are used to measure volatility. They expand when volatility is rising, and contract when it is falling. The bands are a good gauge of volatility with very easily identifiable visual patterns emerging as the market progresses through various phases. In addition, over the years traders have also improvised many different ways of using this indicator for trading decisions. One way is to buy or sell when the price action crosses the upper or lower band, respectively, anticipating a breakout, or a rapid movement of the price. Trades are closed when the price returns to the moving average in the middle. Another way to use this indicator is anticipating a reversal after long periods of low or high volatility. For example, a trader will enter a buy order in an uptrend after the bands remain close together for a long while, anticipating the next leg of the trend to commence soon. There are also many composite strategies using the Bands for anything from confirmation to signal generation for an incipient price phenomenon.
Accessability
Just about any trading platform will come equipped with the Bollinger Bands since it is so popular among traders. The MetaTrader 4 platform, DealBook of GFT Forex, FXCM Trade Station all provide this indicator, as well countless others not mentioned in this article.
Conclusion
Bollinger Bands serve two purposes. They depict market volatility in an easily identifiable form, and they also help us in trading decisions. The creator of the indicator does not claim that the Bands predict anything about future price action, but that doesn't prevent the indicator being very popular in that role. It is, of course, up to you to decide in which way you'll be using the Bands
Note: Past performance is not indicative of future results.
The lower section of the chart demonstrates the Demarker indicator in action. As the price fails to break through 1.4575 level, the indicator fluctuates against the neutral 0.5 level, confirming the indecision of traders. Later, however, the indicator crosses below the 0.5 level decisively, as observed on the chart, confirming the downtrend, and reaching a level very close to zero before finally reversing and approaching the signal line at 0.3. In spite of the developing divergence, price action remains conclusive however, as MA line remains safe, and no actionable, clear signal can be derived at this stage. We give this example to remind the reader once more that it is safe and prudent to avoid taking any position when clear signals backing it are lacking.
Calculation of the Indicator
The Demarker indicator is calculated by first determining a DeMin, and DeMax value, which roughly correspond to the high or low of a particular time period. The obtained values are then plugged into a formula which generates the value of the indicator itself.
If the high of today is greater than the high of yesterday, we set the DeMin value at the difference of highs of the two time periods (High of today - high of yesterday). Otherwise, DeMax is set to zero. Similarly, if the low of today is lower than the low of yesterday, the difference between the lows of the two periods becomes the value of DeMin (low of today- low of yesterday). If the low of yesterday is equal or lower than today's low, DeMin is set to zero.
Now we plug these two values into the formula below:
DeMark = N-period Moving Average of DeMax / (N-period Moving Average of DeMax + N-period Moving Average of DeMin)
Here the moving average can be of any type, but most software packages use the simple moving average for calculation.
Taking a look at this formula, we observe that the value of the indicator will rise when the higher DeMax values are registered (in other words, market records higher highs on), and it will fall when the moving average of the lows attains higher values.
