What do a Hollywood lighting designer and an investment guru have in common?

The answer is John Bollinger. Some of you may be familiar with the technical analysis term “Bollinger bands”; however, what do you know about the man behind the concept? Surprisingly, the president and the founder of Bollinger Capital Management Inc.-a Californian investment company that provides portfolio management and research services for individual and institutional clients since 1988-started his career as a Hollywood architectural lighting designer. At the time, his job requirements included the understanding of physics of light production and distribution as well as people’s psychology of light perception. Those concepts could be easily applied to trading, right? Well, not really.

John Bollinger became interested in financial markets when his mother asked him to look after her retirement portfolio. Bollinger’s inquisitiveness and enchantment with financial markets, combined with a commitment to continuous learning, acquired him the prestigious Chartered Financial Analyst (CFA) and Chartered Market Technician (CMT) designations, and eventually landed him a career as a CNBC chief market analyst.

Nevertheless, his achievements did not end there. His book Bollinger on Bollinger Bands, published in 2001, was a huge success and has been translated into eight languages.

For many people, Mr. Bollinger’s biography is just another American success story; however, his success has helped many traders around the world better comprehend the price oscillations of various markets. I could say that I belong in this camp, since I have used Bollinger bands for years (among other indicators) to help me time the trade entries for options writing. For example, I sold options when the Bollinger bands were historically far apart, and stood on the sidelines when they were historically close together. My expectation in both instances was that the volatility will return to normal historical levels, and in most cases it did.

What are Bollinger Bands?

Bollinger bands are actually three bands – a simple moving average and two standard deviations above and below the average. As you might have guessed, this oscillator is based on two concepts: moving averages and envelops. First of all, Bollinger bands take a simple moving average (SMA). In previous readings, we learned that the SMA is calculated by summing all the closing values over a certain period of time, and dividing the sum by the number of periods. For example, a 20-day SMA represents the sum of the closing values of the last 20 days divided by 20.

Envelopes are symmetrical lines that run in parallel with the moving average, one line above and one line below. John Bollinger illustrates the envelope concept using this Dow Jones Industrial Average (DJIA) chart from a few years back and applying a 21-day simple moving average and two bands that are deployed above and below the moving average by 4%.

Taking this concept a little further, Bollinger Bands are a modified and improved version of envelopes: the bands are more flexible, since they are standard deviations above and below the simple moving average. They are built on the hypothesis that the bands should widen or narrow as the price trend becomes more or less volatile. In the figure below, John Bollinger shows two standard deviations above and below a 20-day simple moving average. The data used to calculate the standard deviations are the same data as those used for the simple moving average.

Bollinger Bands applications

According to John Bollinger, the “bands can be applied to virtually any market or security. For all markets and issues, I would use a 20-day calculation period as a starting point and only stray from it when the circumstances compel me to do so. “

Given the popularity of the bands, there is plenty of information on the web about them, but not all of it is accurate. For example, some websites claim that the bands are based on exponential moving average, instead of simple moving average.

If you are considering incorporating Bollinger bands in your trading routine, here are some of the possible interpretations and admonitions regarding them:

•    Confirming indicators – Indicators used for confirmation should not be closely related to the bands. John Bollinger recommends that the bands should be used in conjunction with a volume indicator such as David Bostian’s Intraday Intensity or Larry Williams’ Accumulation/Distribution. The Intraday Intensity shows the flow of funds, while Accumulation/Distribution gauges supply and demand through divergences between stock price and volume flow, thus using volume to confirm price trends or warn about imminent price reversals. For instance, positive trading days occurring on high volume in a downtrend could signal that the demand for the stock is picking up, and therefore the end of the downtrend.

•    Overbought/oversold conditions – Bollinger Bands help gauge overbought and oversold conditions. For example, when the bands are spread out widely and the stock trades at the upper band, one could consider this stock overbought and expect some price correction.

•    Volatility – the flexibility added by the use of standard deviation means Bollinger Bands have built-in volatility of the underlying trend. For example, Bollinger bands tend to narrow during periods of low volatility and expand during times of high volatility.

•    Continuation Signals – closing values outside Bollinger bands could be interpreted as continuation signals; however, you should not buy solely based on price breaks above the upper Bollinger band or sell just because the price falls below the lower Bollinger band. A buy or sell action should be considered in context, meaning in conjunction with other indicators. However, there are some other interpretations of closing values below the lower Bollinger band. Research conducted in 2007 by Forbes magazine advocates for a buy, instead of sell: “Buying on the break of the lower Bollinger band is a simple strategy that often works. In every scenario, the break of the lower band was in oversold territory. This selling pressure is usually corrected quickly.” Nevertheless, the paper advocates for the use of stop-loss orders to contain negative trades.

•    Buy & Sell signals – Tags of the upper or lower bands should not be considered buy or sell signals. For example, if the price touches the lower Bollinger band it should not be a buy signal by itself and should be taken into consideration with other indicators.

Bollinger bands are versatile and useful. As an added bonus, their developer, John Bollinger, is a current money manager for individuals and institutions alike, proof of the viability of the bands over the last 20 years. For his investment company’s clients’ portfolios, John Bollinger applies “rational” analysis: a decision-making process based on technical, as well as fundamental analysis. In an interview with the LA Times from December 2008, in the midst of the financial crisis, John Bollinger advised investors to take advantage of the attractive securities prices: ‘You don’t get these opportunities all that often, they come separated by decades. And the problem is that investors, when they see these, are reluctant to act because there’s so much damage that’s been done to the system.’ With the benefit of hindsight we can see that his assessment was fairly accurate.

>> BACK TO THE NEWSLETTER: Click here to read other articles from this week’s newsletter