Bollinger Bands

I am not an active trader of stocks or options although I do enjoy reading and studying the methods people use to “time” the markets so to speak. I will confess I have tried to time the markets myself but have gotten whacked more than I care to admit! My issue is I am the best “paper trader” there is but the minute real money is involved I choke. Well, I am being honest at least.

Nonetheless, there are many cool tricks market timers do use which work very well when applied properly. Here is one tool that uses statistics as its backbone – Bollinger Bands.

StockCharts.com explains it as follows:

Developed by John Bollinger, Bollinger Bands are an indicator that allows users to compare volatility and relative price levels over a period time. The indicator consists of three bands designed to encompass the majority of a security’s price action. 1. A simple moving average in the middle
2. An upper band (SMA plus 2 standard deviations)
3. A lower band (SMA minus 2 standard deviations)
Standard deviation is a statistical unit of measure that provides a good assessment of a price plot’s volatility. Using the standard deviation ensures that the bands will react quickly to price movements and reflect periods of high and low volatility. Sharp price increases (or decreases), and hence volatility, will lead to a widening of the bands.
The basic idea is that the stock price will venture towards the upper or lower band and then bounce off it. Sometimes the stock will crawl along the band and then when the bands constrict an explosion will occur. And if you are watching and wait for the breakout (up or down) you can go long or short depending on the situation. See the SBUX picture above and look at how the bands constricted in January and then when the stock hit “support” it took off. Bet you wish you picked that bottom, eh?

Of course this is much easier said then done… but if you fancy a try you can try these bands for free on most stock charts – Google it and you will see. But do me a favor… before you put real money on the line try the old “paper trade” out first.

Until next time, I wish you all the best on your journey towards continuous improvement.

4 Comments

  1. Matt Meyers

    February 20, 2007 - 8:31 am

    I find these things fascinating, as a stats geek and as a amateur trader. Bollinger Bands are based on standard deviation, and using standard deviations implies that the data has a normal distribution. Stock prices are not normally distributed. And yet, Bollinger Bands (and other quant stock techniques assuming normality) work (well, they have their own success rate < 1), despite the mathematical inconsistency, simply because the quant analysts use them. And so the tail wags the dog.

  2. Ron Pereira

    February 20, 2007 - 1:18 pm

    Great comment on normality. I was going to mention this but left it out… I am glad you mention it though since I do think someone could do well developing some non parametric stock market timing tools. Maybe there is an indicator with your name on it Matt! Just remember us little people when they write books about you. Cheers!

  3. Mark Graban

    February 20, 2007 - 4:22 pm

    I’ve always wondered if you could use Statistical Process Control methods for evaluating stocks… to tell if an increase or decrease was “common cause” fluctuation or “special cause” change.

  4. Ron Pereira

    February 20, 2007 - 7:02 pm

    Mark… are you a closet Six Sigma geek? Just joking man. Yeah there are some pretty cool tricks these market gurus use to time things. In the end though it comes down to bulls, bears, and those poor pigs who get slaughtered.