Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

NOVICE TRADER

This indicator combines popular technical methods moving averages, support/resistance, and envelopes with
statistical analysis to create a powerful technical analysis
tool. Bollinger Bands, used in combination with the relative
strength index (RSI) to analyze a market, enables us to
develop a method to enter and exit trades and review the
historical results.
by Stuart P. Evens
n a day-to-day basis, markets
trade in a volatile fashion
around the trend. To better see
the trend, traders use moving
averages to filter the price action. This way, traders can
gather important information
regarding how the market is
trading. For example, after a
sharp rise or fall in the trend,
the market may consolidate,
trading in a narrow fashion and crisscrossing above and
below the moving average. To better monitor this behavior,
traders use price channels, which are designed to encompass
the trading activity around the trend.
Bollinger Bands are one such technical tool. Before we
discuss Bollinger Bands, however, lets have a quick look at
some other methods that traders have used.
Some technicians use moving averages with support and
resistance lines to anticipate the price action of a stock. Upper
resistance and lower support lines are first drawn and then
extrapolated to form channels within which the trader expects prices to be contained. Some traders draw straight lines
connecting either tops or bottoms of prices to identify the
upper or lower price extremes, respectively, and then add
parallel lines to define the channel within which the prices
should move. As long as prices do not move out of this
channel, the trader can be reasonably confident that prices are
moving as expected.
J.M. Hursts Profit Magic Of Stock Transaction Timing
described a method of applying support and resistance theory
to the moving average concept. Rather than using fixed points
such as minor tops or bottoms to construct the channels, Hurst
wrote about a method to add and subtract a fixed percentage
of the daily moving average value to the moving average to
create a band around the stock price. This group of indicators
combines the two popular interpretations of stock price, the

ENVELOPES
Envelopes consist of three lines: a middle one that is a moving
average, and two others that form an upper and lower band,
or envelope, around the price bars of a stock when plotted
together on the same chart. The theory behind them is that the
moving average represents the trend of the stock price, and
the upper and lower lines indicate when temporary price
extremes in that stock exist. When prices reach the upper line,
or especially when they exceed the line, a warning is given for
the possibility of a correction in the opposite direction that
is, down. Likewise, when prices reach or exceed the lower
line, an extreme level of selling is indicated, and it is reasonable to expect a movement up in prices.
Different variables are used in constructing envelopes, and
depending on the selection, the amount of price data within
the bands will also vary. Regardless of variables used, all
envelopes start with a moving average, usually of the closing
price of the stock. It can be a simple moving average, an
exponential moving average, or a weighted moving average.
In addition to the method of calculating the moving average, varying the length of the average greatly influences how
it reacts to price changes. A shorter moving average for
example, 20 days is much more sensitive to price changes
than a 200-day moving average. Therefore, if you wanted to

FIBONACCI TRADER

Bollinger
Bands

moving average and support and resistance.

Technicians call these envelopes or trading bands, and it is
in this group that Bollinger Bands belong. John Bollinger
used statistical analysis to come up with a technical analysis
tool to determine when to buy and sell. I will discuss envelopes in general and Bollinger Bands specifically. We will
also look at the logic behind these tools, how they are
calculated and plotted, and how they can be used in trading.
But before we do that, lets look into envelopes.

FIGURE 1: ENVELOPES AROUND DOW CHEMICAL, USING FIBONACCI TRADER.

Here, we see 3% envelopes around Dow Chemical. The center (blue) line is the 20day simple moving average of closing prices, and both the upper and lower (red)
lines make up the envelope. The upper line is a plot of the 20-day moving average
plus 3% of the moving averages value, and the lower line is a plot of the 20-day
moving average minus 3% of the averages value . Note how the price bars leave
the envelope during periods of sharp downward and upward price movement.

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Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

follow the short-term trend, you

would choose the 20-day over
the 200-day, and a 200-day
moving average is often used
to follow long-term trends in
stock prices.
Another consideration in constructing envelopes is the method
used to calculate the upper and
lower lines around the moving
average. Figure 1 illustrates one
common method, using a 20day simple moving average of
closing prices as the center line
of the envelope. The upper and
lower lines are a predetermined
percentage of the moving average, away from the center moving average line. In this case,
both lines are 3% away from the
middle line. The upper line is
calculated by multiplying each
daily value of the 20-day moving average by 1.03 (1 + 0.03)
and plotting that value. The lower
line is calculated by multiplying
each days moving average by
0.97 (1 - 0.03) and plotting that
value. This is the method described by Hurst.

PATRICK KELLEY

BOLLINGERS BANDS
John Bollingers modification to
envelopes, known as Bollinger
Bands, are a moving average
envelope or trading band that
combines statistics with envelope theory. Bollinger used statistical analysis of stock prices
to calculate his bands because
he felt that the bandwidth should
be correlated to the price action
of the underlying stock instead
of the arbitrary fixed percentage
method for choosing the bandwidth used in Figure 1.
The statistical portion of his
method is that the bandwidth is
two standard deviations away
from the center moving average
line. The significance of two
standard deviations is wellknown in statistics, as 95.5% of
the population data values in a
normal distribution occur within
plus or minus two standard deCopyright (c) Technical Analysis Inc.

Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

viations of the population mean. From this theory, as applied

to Bollinger Bands, we can infer that 95% of the stocks price
action should be contained between the upper and lower band
lines, since they are two standard deviations away from the
middle moving average of price.
Figure 2 shows Dow Chemical, the same as in Figure 1,
with Bollinger Bands plotted. More of the price movement is
contained by Bollingers bands compared with the envelopes
using the fixed percentage method as in Figure 1, even during
periods of volatility in the stock price.
This difference in the amount of price containment illustrates another reason why John Bollinger chose standard
deviation as the method for determining bandwidth. Standard
deviation is sensitive to sharp changes in volatility, so Bollinger
Bands react more quickly to price changes than envelopes
with fixed percentage bandwidth and therefore encompass a
larger portion of the stocks price movement. Look at how the
width between the moving average line and both the upper
and lower band lines changes depending on the direction of
prices, and on how rapidly they move in that direction.
The bands widen during periods of high volatility and
contract during periods of low volatility. Figure 2 shows
Dow Chemical during the week of September 1, 1998, with
relatively volatile price action. Compare the bandwidth
during this week with the bandwidth during July 1998. As
you can see, the bands are much wider during September
1998 than July 1998. In fact, as the share price settles down
during July, the bands become quite narrow. This figure
illustrates the responsiveness of Bollinger Bands to different market conditions.
The technician chooses the length of the moving average
around which the bands are plotted; the length should be
based on the trend you wish to follow short, intermediate,
or long term. Bollinger chose a 20-day moving average for
the intermediate-term trend, which he felt was a good choice
for the market indices and individual stocks. He suggests a
10-day moving average for the short-term trend and a 50-day
average for the long-term trend.
In choosing the length of the moving average, the goal is
to select one that provides support to prices. We dont want
a length that is either too frequently broken or too far away
from the price action. A good way to let the market tell you
what length to use is to look for significant turning points in
the market, such as tops and bottoms that trace out an M or
W pattern. The average to use is the one that supports the
turning points in most cases.
In any event, as the length of moving average is increased
or decreased, the number of standard deviations that are
added and subtracted should also be adjusted accordingly.
For a 50-day moving average, two and a half standard
deviations seem to work well. For following the shorter-term
trend using a 10-day moving average, a reduction in bandwidth to one and a half standard deviations is a good choice.
As for choosing which price of which to take a moving
average, there are a variety of choices. For our analysis, we
will take a moving average of closing prices, but typical price

FIGURE 2: BOLLINGER BANDS AROUND DOW CHEMICAL. This figure shows

Bollinger Bands around Dow Chemical during the same period as Figure 1. Again, the
center line (blue) is the 20-day simple moving average, and the upper and lower (red)
lines are the Bollinger Bands. The upper line is a plot of the 20-day moving average
plus two standard deviations and the lower line is the 20-day moving average minus
two standard deviations. When compared to Figure 1, note how much more of the
price bars are contained by Bollinger Bands during sharp price movement.

or weighted close can also be used, as described in Bollingers

February 1992 article. The typical price is calculated by
summing the close, high, and low of the day, and dividing by
three. The weighted close is the sum of the high and the low,
and two times the close, divided by four.
A mathematical summary for the calculation of Bollinger
Bands can be seen in Figure 3. These formulas describe a 20day simple moving average of closing prices, with
N
bandwidths of two stan2
Xj X
dard deviations. The varij=1
=
able N in these equations
N
is the length of the movN
ing average being used,
Xj

and its value can be

X = j=1
N
changed, depending on the
trend you wish to follow.
Upper band = X + 2
Middle band = X
INTERPRETATION
Lower band = X 2
Envelopes in general and
Bollinger Bands in specific
are used to indicate rela- FIGURE 3: BOLLINGER BAND MATH.
These are the equations for calculating the
tive extremes in price. three lines that make up Bollinger Bands. N
When the price is trading is the number of days used to calculate the
at or above the upper moving average and the upper and lower
Bollinger band line, the lines. For the intermediate-term trend,
Bollinger suggested 20 days, which is the
trader should beware; the value we used in Fgure 2 and for all of the
stock might be overbought. examples.
Further, when prices are at
or below the lower band
line, there is a probability that the stock is oversold.
If this sounds vague, it is. Bollinger states that his bands do
not give buy and sell signals just because the price bumps up
against the band lines. This is only an indication that the price

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Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

FIGURE 4: BOLLINGER BANDS AND RSI. The 20-day RSI is shown below the plot
of prices and Bollinger Bands. We will use the RSI to confirm the indication by
Bollinger Bands that prices are relatively high or low and place hypothetical trades
based on historical prices when these two indicators agree.

METASTOCK FORMULAS
Enter Long:
Low < = BBandBot(C,20,S,2) and RSI(20) < 30
Close Long:
High >= BBandTop (C,20,S,2) and RSI(20) > 70
Enter Short:
High >= BBandTop (C,20,S,2) and RSI(20) > 70
Close Short:
Low <= BBandBot(C,20,S,2), and RSI(20) < 30
FIGURE 5: TRADING RULES. The trading rules used on historical prices in our
examples are shown in Figure 5, written in MetaStock formula language. In each
example, MetaStocks system tester was used to place hypothetical trades using
the above rules during the historical period starting in January 1993 and ending in
December 1998. The rules are based on price relative to Bollinger Bands, confirmed
by the 20-day RSI.

METASTOCK (EQUIS INTERNATIONAL)

is high or low on a relative basis, depending on which band

the price is bumping. Any action taken should be confirmed
or signaled by another indicator or indicators.
This, of course, begs the question of which indicator to use
with Bollinger Bands. The one thing you want to avoid when
using multiple indicators is thinking that you are getting
independent confirmation of a trend, because you may not be.
You want to choose indicators not correlated to a significant
degree. If you select two indicators that both happen to be
calculated using daily range, chances are you really dont
have independent confirmation.
In selecting your indicators, you want to pick those based
on varying data. For example, choosing three indicators with
one calculated from closing prices, one from daily volume,
and one from daily price range should result in a combination
that is probably not significantly correlated. Bollinger suggests that a good choice, based on price alone, to be used with
his bands is the relative strength index (RSI). On-balance
volume is his selection using closing prices and volume, and
his price range and volume choice is money flow.
Once we have our Bollinger Bands plotted and have
selected and plotted our additional indicator, we begin our
analysis on the premise that prices at the upper band are
relatively high, and conversely, prices at the lower band are
relatively low. We then look to the other indicator to signal
the buy or sell. If the other indicator confirms the high or low,
depending on which band the stock is trading at, there is a
good chance that prices will continue in the same direction.
If, however, the other indicator diverges, then we look to sell
the stock when its price reaches the upper band and buy the
stock when its price reaches the lower band.
Lets look at some examples. Figure 4 again shows Dow
Chemical from March 1998 to December 1998, with prices
touching the upper and lower bands. If we used the occurrence of the price touching one of the Bollinger Bands as the
only indicator to enter and exit trades, we would have had a
number of losing trades. Instead, let us limit our trades to only
those confirmed by the 20-day RSI, as seen at the bottom of
Figure 4. Well use a common interpretation of the RSI to
define confirmation of what Bollinger Bands say about stock
prices at the upper and lower band lines.
Prices are considered overbought when the RSI is above
70, and prices are considered oversold when the RSI is less
than 30. This is a gross oversimplification, and before you use
this indicator, I would caution you to fully understand the RSI
before using it in your trading rules. It is quite common for the
RSI to indicate an overbought or oversold condition, even as
the stock continues to trade higher or lower, respectively.
However, the simple 30/70 threshold level interpretation of
the RSI will be adequate for our discussion of Bollinger Bands
and provide us with a simple confirmation on which to base
hypothetical trades using historical data.
Our trading rules are that we will go long when the price
touches the bottom Bollinger band at the same time the 20period RSI is less than 30, and we will go short when the price
touches the upper Bollinger band at the same time the 20-

FIGURE 6: DOW CHEMICAL, BOLLINGER RESULTS. The historical results for

Dow Chemical are shown in Figure 5. The red arrows represent short trades and the
green arrows represent long trades. The red equity line is shown above the price
bars, which shows a total profit of 50.438 points.

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Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

Exit signs

Long

FIGURE 7: DOW CHEMICAL, BUY AND HOLD RESULTS. The historical results for
Dow Chemical using buy-and-hold are shown here. One green arrow at the far left
of the price charts represents the long position, and the equity line shows an
historical profit of 34.713 points.

FIGURE 8: DOW CHEMICAL, BOLLINGER (LONG ONLY) RESULTS. The historical

results for Dow Chemical are shown in Figure 8, but only taking the long side of our
trading rules. Instead of going short, we just exit the market and stay flat, which is
why we get flat spots in our equity line. The exit points are represented by the red
exit signs in the price bar graph.

period RSI is greater than 70. We can summarize our trading

rules for MetaStock based on Bollinger Bands and the RSI as
follows:

We tested our trading rules using MetaStocks system tester

with our rules written in MetaStock formula language, as can
be seen in Figure 5. Low and high refer to the daily low and
high of the stock. The trading rules use a 20-day RSI to
confirm the overbought/oversold status of the stock before
taking a position. The conditions for entering long and
closing short positions are the same, as are the conditions for
closing long and entering short positions. This is known as
stop and reverse (SAR), and with this method, we are always
in the market, long or short.
The plot of Dow Chemical from January 1993 to December 1998 can be seen in Figure 6, with the long and short
trades represented by the green and red arrows, respectively,
generated by MetaStocks system tester using the points-only
method of testing. Commissions were taken into account,

Enter Long:
Low < or = Bollinger band bottom line, and
RSI(20) < 30
Close Long:
High > or = Bollinger band top line, and
RSI(20) > 70
Enter Short:
High > or = Bollinger band top line, and
RSI(20) > 70
Close Short:
Low < or = Bollinger band bottom line, and
RSI(20) < 30

FIGURE 9: DOW CHEMICAL, BOLLINGER (SHORT ONLY) RESULTS. Figure 9

shows the historical results for the short side only of our trading rules. The equity
line shows that each of the short trades experienced a drawdown at some point
during the trade, and it might be difficult to hold on to trades like these.

FIGURE 10: FLUOR-BUY AND HOLD RESULTS. If we had bought Fluor in January
1993 and held the stock until December 1998, we would have received 2.025 points
for our patience. However, we would have had to withstand a drawdown of about
seven points after being up as much as 35 points at one point during the position.

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Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

FIGURE 11: FLUOR, BOLLINGER RESULTS. If we had traded Fluor during this same
period using the long and short side of our rules, we would have made 65.075 points
but would have had to withstand an 11-point drawdown. We would have been exposed
to the market for a shorter period using this method, compared with buy and hold.

FIGURE 12: FLUOR, BOLLINGER (LONG ONLY) RESULTS. If we had traded Fluor
during the same period but only from the long side using our Bollinger/RSI rules, we
would have made a historical profit of 31.712 points. However, we would have had to
stomach a 10- or 11-point drawdown on the third and last long position during this period.

with $5 entry and $10 exit commissions deducted. Slippage

was not taken into consideration, and account equity was
calculated based on trades being executed at the opening
price of the stock on the day after the signal was generated,
using end-of-day data from Track Data. The equity line, in
points, is represented by the red line above the price bars.
With these limitations, these rules for Dow Chemical
produced a historical profit of 50.438 points during this
period. This was during a general uptrend in the stock, as
represented by the trendline. How does this result compare
with buy and hold? Figure 7 shows the stock during the
same period, but buying the stock in January 1993 and
holding it to the end of the period. The historical profit using
this method is 34.713 points. Both methods had to endure an
initial losing position, but more with the Bollinger band/RSI
method than buy and hold.

Figure 6 shows both long and short trades, whereas

Figure 7 shows only one long position. Since some traders
might not be comfortable shorting a stock, lets consider the
case of only taking the long side of our trading rules exit
our long position and go flat until our next buy signal.
Figure 8 shows this scenario, again with Dow Chemical
over the same period. The historical profit for the long side
of our rules is 38.113 points, only very slightly better than
buy and hold. However, the position never experiences a
negative account equity, though the last three trades do
show an unrealized loss.
The most significant point shown in Figure 8 is that, during
this period, the results for Dow Chemical were better than
buy and hold, but with much less risk. That means that using
the long side of the Bollinger band/RSI trading rules, we were
not in a position or exposed to the market nearly as long as the

FIGURE 13: FAIR ISAAC, BUY AND HOLD RESULTS. Buying Fair Isaac in January
1993 and holding it until December 1998 would have returned 34.90 points, with no
drawdown during this period.

FIGURE 14: FAIR ISAAC, BOLLINGER RESULTS. The Bollinger/RSI rules would
have returned a historical profit of 67.726 points but also would have produced a
nasty 21-point drawdown had we been without stop-loss provisions.

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Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

FIGURE 15: FAIR ISAAC, BOLLINGER (LONG ONLY) RESULTS. If we had taken
the long side only of our Bollinger/RSI trading rules, we would have had a historical
profit of 50.663 points during this time. In this case, the account would not have
experienced any negative account equity during this period, though three of the five
trades would have experienced small drawdowns.

FIGURE 16: IBM, BUY AND HOLD RESULTS. The best of the three methods
historically, buy and hold would have returned a profit of 243.46 points with a very
reasonable five- or six-point drawdown early in the position.

buy and hold method. The longer a position is held, the more
likely it is that something will go wrong.
The short side only of our trading rules is shown in Figure
9 with quite a volatile equity line, even though the short side
has a net profit of 12.325 points over this period. However, it
would be very hard to hold these short positions, given the
amount of drawdown shown in the equity line in Figure 9.
Lets look at another example, this time of Fluor during the
same period. Figure 10 shows buy and hold with a net
historical profit of 2.025 points and a maximum negative
equity of about seven points. Figure 11 shows Fluor during
the same period, with trades shown using our Bollinger band/
RSI trading rules. This method had a historical profit of
65.075 points, but there was a negative account equity of
about 11 points, considerably more than buy and hold.

Figure 12 shows Fluor with only the long trades, which

returns a historical profit of 31.712 points and no negative
account equity. However, two of the three trades do have
drawdowns before turning profitable, and the third has a
significant one at that. But we are exposed to the market for
much less time than buy and hold and the reward is also much
greater as well. The short side of our Bollinger/RSI method
was even more profitable (34.113 points) than the long side.
Another stock, Fair Isaac Co., can be seen in Figures 13,
14, and 15, using buy and hold, Bollinger/RSI, and Bollinger/
RSI-long only, respectively. The historical profits were 34.90
for buy and hold, 67.726 for Bollinger/RSI (long and short),
and 50.663 for Bollinger/RSI-long only. Of the three methods, only the Bollinger/RSI (long and short) method experienced a negative account equity line a whopping 21 points,

FIGURE 17: IBM, BOLLINGER RESULTS. The trading rules would have returned
a very dismal historical loss of 112.76 points. We can conclude that we do not have
the Holy Grail of trading methods, as the equity line above shows.

FIGURE 18: IBM, BOLLINGER (LONG ONLY) RESULTS. Here, we see the long
side only of our trading rules for IBM, returning a historical profit of 16.663 points.
This is a much smaller profit than buy and hold, but we would have been exposed
to the market only a fraction of the time had we used the buy and hold method.

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Stocks & Commodities V17:3 (116-123): Bollinger Bands by Stuart Evens

thanks to the initial short position (Figure 14). We did not

have any stop-loss provisions in our rules, and it is likely
that any viable trading system would stop out of the position
long before being anywhere near 21 points in the red.
Finally, our last example in Figures 16, 17, and 18 show
IBM during the same time frame using the same trading
methods: buy and hold, Bollinger/RSI (long and short), and
Bollinger/RSI-long only. In these three examples, buy and
hold was far superior, with a historical profit of 243.46 points,
compared with a loss of 112.76 for Bollinger/RSI long and
short, and a profit of 16.663 for Bollinger/RSI long only.
Clearly, we have not discovered the Holy Grail of trading
methods, and any method we use to trade requires sound
money management techniques, stop-loss provisions, and
extensive historical testing before risking any money.

CONCLUSIONS
Does the fact that our rules didnt produce a profit historically
for IBM imply that a trading method that includes Bollinger
Bands and RSI isnt worth considering? No. There is no
method that is 100% profitable for all stocks during all market
conditions. The goal is to develop the skills to recognize
stocks and market conditions that can be traded profitably
using your method, whatever that may be. Whether or not
Bollinger Bands/RSI is a tool that you can use to trade
profitably depends on many things, including historical testing of the markets you trade, money management, and last but
not least, your own personal trading style.

Chande, Tushar, and Stanley Kroll [1993]. Stochastic RSI

And Dynamic Momentum Index, Technical Analysis of
STOCKS & COMMODITIES, Volume 11: May.
Edwards, Robert D. and John Magee [1992]. Technical
Analysis Of Stock Trends, John Magee, Inc.
Hurst, J.M. [1970]. Profit Magic of Stock Transaction Timing, Prentice-Hall.
Lapin, Lawrence L. [1987]. Statistics For Modern Business
Decisions, Harcourt Brace Jovanovich.
Murphy, John J. [1996]. The Visual Investor, John Wiley &
Sons.
Star, Barbara [1993]. RSI Variations, Technical Analysis of
STOCKS & COMMODITIES, Volume 11: July.
Sweeney, John [1997]. The Relative Strength Index (RSI),
Technical Analysis of STOCKS & COMMODITIES, Volume
15: September.
Wilkinson, Chris [1997]. Technically Speaking, Traders Press:
Greenville, SC.
See Traders Glossary for definition

Stuart Evens is a Staff Writer for STOCKS & COMMODITIES.

REFERENCES AND RELATED READING

Achelis, Steven B. [1995]. Technical Analysis From A To Z,
Probus Publishing.
Barnes, Robert M. [1997]. Trading In Choppy Markets, Irwin
Professional Publishing.
Bollinger, John [1992]. Using Bollinger Bands, Technical
Analysis of STOCKS & COMMODITIES, Volume 10: February.

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