Technical Indicators 101- Bollinger Bands

by 30 Jun, 2020

Technical Indicators 101- Bollinger Bands

Disclaimer: I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand!

Bollinger Bands are a technical charting indicator created by John Bollinger in the 1980s. At its most simple Bollinger Bands are three lines, the middle line is a moving average, the top line represents an overbought level, and the bottom line represents an oversold level. The moving average line is in the center, and is a simple moving average, averaging the last 20 days’ prices. The top and bottom line’s are sized based on volatility. Volatility is calculated from the standard deviation of closing prices of last 20 days. Standard deviation is the average of how far each day’s closing price is from the mean closing price, or the average deviation from the mean closing price. The idea is that the Bands are tighter when volatility is low and wider when volatility is high. This means that in higher volatility regimes that the price will need to be higher than in normal regimes to be considered overbought.

Essentially Bollinger Bands are used to determine when securities are relatively cheap compared to the last 20 days and relatively expensive compared to the last 20 days. Knowing when stocks are relatively overvalued is very useful, especially when combined with other indicators like the RSI (see article). Since Bollinger Bands are a lagging indicator they cannot predict moves, however there are two main applications. One common application is referred to as a “Bollinger Squeeze”, this is characterized by low volatility, shrinking of the bands and thus the chart looks like a squeeze.  When you get the first “breakout” above or below the band, it is expected that after there will be a period of higher volatility. Another application is to bet on mean reversion. This is done by buying when the price touches the lower oversold indicating band, and short selling when the price touches the upper, overbought band. Do keep in mind that this last method is not what Bollinger Bands were designed to do.

I did however test this strategy historically. The system would buy at the close if the lower band was hit during the day, and it would sell at the close if the upper band was hit during the day. The holding period was 24 hours. I used the past 10 years of SPY as a trial period and the results were generally positive. The Bollinger strategy had an average return of .0659% while SPY had 0.489%. SPY had a sharpe ratio of .76 while SPY only had .71. Sharpe ratio is a ratio of risk adjusted return, how much return you get per unit of risk (risk=volatility). To summarize some other metrics, the Bollinger strategy had about a 50% less deep drawdown, but the drawdown was about 50% longer, the main pitfall of this strategy statistically is that it is only in the market 15% of the time. In addition, there was a fundamental problem. Think about this- the upper band is hit, but momentum is extremely strong from news of a potential Covid vaccine, of course then the upper band does not mean that SPY is overvalued, so you should not short. But the program would have told you to. Thus, it is important to remember that Bollinger Bands cannot replace a fundamental analysis and that Bollinger Bands do not take into account news or any non-price data. So in extraordinary times, they may fail. But Bollinger Bands become even more powerful when combined with other indicators like the RSI. For example, if Bollinger Bands indicate a stock is overbought, and has downward momentum, this is likely a strong short signal.

Invstr provides Bollinger Bands on any stock! To find it, go to a stock’s chart, click on the bottom right on “technicals” tap the middle button in the top right of the screen, and click “Bollinger Band overlay”. 

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