There is an interesting technical indicator developed by John Bollinger in the early -1980s. This indicator combines the concept of standard deviations with moving averages. A Bollinger Band is basically a trading band that comprises of a middle band and two outer bands (upper and lower). The middle band is typically a 20-period moving average. The outer bands consist of defined standard deviations (typically 2-standard deviation) above (upper band) and below (lower band). In a normal distribution a security’s price can trade within 1-standard, 2-standard or 3-standard deviation over a specified timeframe. 1-standard deviation typically captures 68.2% of the price move, 2-standard deviation captures 95.4%, and 3-standard deviation covers 99.7%. We believe 2-standard deviation will do a good job of capturing the bulk of a move in stock market indexes and individual stocks.
The main objective of deploying Bollinger Bands is to determine how prices trade around an average value (20-day ma) and its response to changing volatility (2-standard deviation). It is another useful technical tool for investors and traders to help quantify the market/security high and low volatility levels, as well as overbought/oversold condition, and most important, to warn of a potential trend change.
Since volatility is based on the standard deviation, the bands tend to change as volatility increases and decreases. The bands contract when volatility falls and will widen when volatility expands. The extreme contraction of the bands will often lead to an explosive price move as volatility returns to normal.
Astute investors and traders typically utilize Bollinger Bands along with other technical indicators (i.e., MACD, RSI, etc.) to improve short-term trading setups and to provide more reliable buy and sell signals.
Attached below you will find Bollinger Bands on key market indexes including S&P 500 Index (SPX), Dow Jones Industrial Average (INDU), NASDAQ Composite Index (COMPQ), and NYSE Composite Index (NYA).
A brief review of the four market indexes show that they are all trading near the upper end of their respective Bollinger Bands. This suggests the indexes are nearing overbought levels. However, if the dominant primary trend is in a solid uptrend it will likely persist further as an overbought condition can stay at overbought levels before it finally corrects. Repeated failures to clear above the top of its Bollinger Bands coupled with visible divergences in the technical indicators (i.e., advance-decline line, MACD, and % of Stocks trading above its 200-day ma) warns of the start of a near-term price consolidation. In a normal correction in a market or security that has a strong rising uptrend, the middle of the bands typically acts as key initial support. The bottom of the bands often represents oversold conditions and pivotal medium-term support.
SPX – upper band = 3,119.78, middle band = 3,046.63, and lower band = 2,973.48
INDU – upper band = 27,934.67, middle band = 27,236.09, and lower band = 26,537.50
COMPQ – upper band = 8,584.54, middle band = 8,313.44, and lower band = 8,042.34
NYA – upper band = 13,499.89, middle band = 13,235.44, and lower band = 12,970.98