Doğu Akdeniz Üniversitesi
Faculty of Business and Economics
Department of Banking and Finance
Saeed Ebrahimijam
FINA417
Spring 2013
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Trading Band
Bollinger Band
Fundamentals of Technical Analysis and Algorithmic Trading
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In chapter 11, you learned how moving
averages are used to smooth price
fluctuations and get a clearer picture of a
security’s price trend.
In this lesson, two moving average filters are
discussed: trading bands and Bollinger Bands.
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and Algorithmic Trading
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Trading bands (also known as envelopes)
create a filter around a moving average line.
Two lines, one above and one below, are
drawn parallel to the moving average.
The distance between the moving average
and the upper and lower trading bands is a
certain percentage.
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and Algorithmic Trading
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For example, Figure 12-1 shows a 21-day
simple moving average of the S&P 500 index
closing prices with trading bands at 4 percent
above and 4 percent below the moving
average.
Note that only the daily closing prices (not
the high-low range) are plotted. This makes it
easier to spot when prices cross over the
moving average and trading band lines.
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and Algorithmic Trading
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1. The majority of price movement occurs
inside the upper and lower trading bands.
2. Prices tend to move back and forth between
the upper and lower trading bands.
3. The moving average (mid-band line) often
acts as support or resistance.
4. When prices cross above the upper trading
band, great market strength is signaled. On
the other hand, when prices move below the
lower trading band, great market weakness is
signaled.
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and Algorithmic Trading
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The same four observations can be made
when examining other trading band charts.
They serve as the basis for the variety of
trading band systems that have been
developed over the years by technicians.
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and Algorithmic Trading
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and Algorithmic Trading
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Trading bands can be successfully applied to
various types of investments (individual
stocks, the overall stock market, ETFs,
commodities, etc.) and investment time
horizons ranging from those that are very
short term to very long term.
The following three steps can be used to
construct valid trading bands and interpret
price action relative to such trading bands:
Fundamental of Technical Analysis
and Algorithmic Trading
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The first step is the easiest of the three steps.
You simply select the individual security or
market you which to trade and define your
investment time horizon (very short term,
short term, intermediate term, long term, or
very long term).
Fundamental of Technical Analysis
and Algorithmic Trading
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Select a moving average length.
The type of moving average you use can be
simple, weighted, or exponential.
However, the much-easier to calculate simple
moving average tends to work just as well as
weighted or exponential averages when used
for trading band purposes.
As is the case when you use a moving
average by itself, you want the length to
correspond closely to a dominant cycle in the
particular security or market you are trading.
Fundamental of Technical Analysis
and Algorithmic Trading
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The third step is the most time-consuming.
In it you determine the appropriate percentage
distance the upper and lower trading bands
should be from the moving average and interpret
price action relative to those trading bands. Keep
in mind that if trading bands are set too close or
too far from the moving average, they will lose
their effectiveness.
As a general rule of thumb, trading bands should
be set so that 70 to 85 percent of all price
movement occurs between the upper and lower
trading bands.
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and Algorithmic Trading
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Trading bands can be used in a mechanical
fashion by generating buy and sell signals when
prices move through the upper and lower trading
bands.
However, they are best viewed subjectively and
used in conjunction with other technical
indicators.
(i.e., as prices approach the upper trading band, watch for a top;
as prices fall to near the lower trading band, look for a bottom)
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and Algorithmic Trading
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The technique of Bollinger Bands was
developed by John Bollinger (Capital Growth
Letter) for the purpose of factoring in price
volatility.
Bollinger Bands are effective for virtually any
security or market and for any investment
time horizon.
Fundamental of Technical Analysis
and Algorithmic Trading
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Rather than placing bands at a certain percentage
distance from a moving average line as is done
with trading bands, Bollinger Bands are placed
two moving standard deviations above and below
a simple moving average line.
More specifically, the bands are placed above and
below a simple moving average at a distance of
two times the root mean square of the deviations
from the average. The amount of data used in the
calculation is equal to the number of periods
used for the simple moving average.
For example, if you use a 20-day simple moving
average, all calculations should be based on 20
days of data.
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and Algorithmic Trading
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and Algorithmic Trading
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There is no set number of periods to use for
the simple moving average or number of
standard deviations above and below that
work best in all markets and for all
investment time horizons.
As with many technical indicators, only by
experimenting with the particular security or
market you are trading can you determine the
best combination of simple moving average
and standard deviations to use in plotting
Bollinger Bands.
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and Algorithmic Trading
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The recommendation is made that you use a 10period simple moving average with bands 1.5
moving standard deviations above and below for
short-term analysis as illustrated in Figure 12-2.
For intermediate-term analysis, a 20-period
simple moving average with bands 2.0 moving
standard deviations above and below can be used
(see Figure 12-3 for an example).
Long-term analysis can be accomplished with a
50-period moving average with bands 2.5
moving standard deviations above and below
(see Figure 12-4 for an example).
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and Algorithmic Trading
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Although calculating Bollinger Bands is
complex, interpreting the indicator is one
Bollinger Band to the other.
This gives you an opportunity to project price
levels to be reached.
Again, as with normal trading bands:
when prices close above the upper Bollinger
Band, it is a sign of great market strength and
a buying opportunity.
when prices close below the lower Bollinger
Band, great market weakness is signaled.
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and Algorithmic Trading
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The upper and lower Bollinger Bands move
closer to the simple moving average line.
There is a tendency for sharp price moves
after such occurrences.
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and Algorithmic Trading
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Finally, tops and bottoms made outside the
bands followed by tops and bottoms made
inside the bands indicate a trend reversal:
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When price tops form first above the upper
Bollinger Band and then below it, a reversal in
trend from up to down is signaled.
Conversely, when price bottoms develop first
below the lower Bollinger Band and then
above it, a trend reversal from down to up is
signaled.
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and Algorithmic Trading
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and Algorithmic Trading
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and Algorithmic Trading
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and Algorithmic Trading
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and Algorithmic Trading
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and Algorithmic Trading
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