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Bollinger Bands: Novice Trader
Bollinger Bands: Novice Trader
NOVICE TRADER
Bands
used statistical analysis to come up with a technical analysis
tool to determine when to buy and sell. I will discuss enve-
lopes 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, let’s look into envelopes.
moving as expected.
J.M. Hurst’s 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 FIGURE 1: ENVELOPES AROUND DOW CHEMICAL, USING FIBONACCI TRADER.
such as minor tops or bottoms to construct the channels, Hurst Here, we see 3% envelopes around Dow Chemical. The center (blue) line is the 20-
wrote about a method to add and subtract a fixed percentage day 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
of the daily moving average value to the moving average to plus 3% of the moving average’s value, and the lower line is a plot of the 20-day
create a band around the stock price. This group of indicators moving average minus 3% of the average’s value . Note how the price bars leave
combines the two popular interpretations of stock price, the the envelope during periods of sharp downward and upward price movement.
BOLLINGER’S BANDS
John Bollinger’s modification to
envelopes, known as Bollinger
Bands, are a moving average
envelope or trading band that
combines statistics with enve-
lope theory. Bollinger used sta-
tistical 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 band-
width 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 well-
known in statistics, as 95.5% of
PATRICK KELLEY
Exit signs
Long
FIGURE 7: DOW CHEMICAL, BUY AND HOLD RESULTS. The historical results for FIGURE 8: DOW CHEMICAL, BOLLINGER (LONG ONLY) RESULTS. The historical
Dow Chemical using buy-and-hold are shown here. One green arrow at the far left results for Dow Chemical are shown in Figure 8, but only taking the long side of our
of the price charts represents the long position, and the equity line shows an trading rules. Instead of going short, we just exit the market and stay flat, which is
historical profit of 34.713 points. 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 We tested our trading rules using MetaStock’s system tester
rules for MetaStock based on Bollinger Bands and the RSI as with our rules written in MetaStock formula language, as can
follows: be seen in Figure 5. Low and high refer to the daily low and
Enter Long: high of the stock. The trading rules use a 20-day RSI to
Low < or = Bollinger band bottom line, and confirm the overbought/oversold status of the stock before
RSI(20) < 30
taking a position. The conditions for entering long and
Close Long: closing short positions are the same, as are the conditions for
High > or = Bollinger band top line, and closing long and entering short positions. This is known as
RSI(20) > 70 stop and reverse† (SAR), and with this method, we are always
in the market, long or short.
Enter Short:
High > or = Bollinger band top line, and The plot of Dow Chemical from January 1993 to Decem-
RSI(20) > 70 ber 1998 can be seen in Figure 6, with the long and short
trades represented by the green and red arrows, respectively,
Close Short:
generated by MetaStock’s system tester using the points-only
Low < or = Bollinger band bottom line, and
RSI(20) < 30 method of testing. Commissions were taken into account,
FIGURE 9: DOW CHEMICAL, BOLLINGER (SHORT ONLY) RESULTS. Figure 9 FIGURE 10: FLUOR-BUY AND HOLD RESULTS. If we had bought Fluor in January
shows the historical results for the short side only of our trading rules. The equity 1993 and held the stock until December 1998, we would have received 2.025 points
line shows that each of the short trades experienced a drawdown at some point for our patience. However, we would have had to withstand a drawdown of about
during the trade, and it might be difficult to hold on to trades like these. seven points after being up as much as 35 points at one point during the position.
FIGURE 11: FLUOR, BOLLINGER RESULTS. If we had traded Fluor during this same FIGURE 12: FLUOR, BOLLINGER (LONG ONLY) RESULTS. If we had traded Fluor
period using the long and short side of our rules, we would have made 65.075 points during the same period but only from the long side using our Bollinger/RSI rules, we
but would have had to withstand an 11-point drawdown. We would have been exposed would have made a historical profit of 31.712 points. However, we would have had to
to the market for a shorter period using this method, compared with buy and hold. 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 Figure 6 shows both long and short trades, whereas
was not taken into consideration, and account equity was Figure 7 shows only one long position. Since some traders
calculated based on trades being executed at the opening might not be comfortable shorting a stock, let’s consider the
price of the stock on the day after the signal was generated, case of only taking the long side of our trading rules — exit
using end-of-day data from Track Data. The equity line, in our long position and go flat until our next buy signal.
points, is represented by the red line above the price bars. Figure 8 shows this scenario, again with Dow Chemical
With these limitations, these rules for Dow Chemical over the same period. The historical profit for the long side
produced a historical profit of 50.438 points during this of our rules is 38.113 points, only very slightly better than
period. This was during a general uptrend in the stock, as buy and hold. However, the position never experiences a
represented by the trendline. How does this result compare negative account equity, though the last three trades do
with buy and hold? Figure 7 shows the stock during the show an unrealized loss.
same period, but buying the stock in January 1993 and The most significant point shown in Figure 8 is that, during
holding it to the end of the period. The historical profit using this period, the results for Dow Chemical were better than
this method is 34.713 points. Both methods had to endure an buy and hold, but with much less risk. That means that using
initial losing position, but more with the Bollinger band/RSI the long side of the Bollinger band/RSI trading rules, we were
method than buy and hold. 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 FIGURE 14: FAIR ISAAC, BOLLINGER RESULTS. The Bollinger/RSI rules would
1993 and holding it until December 1998 would have returned 34.90 points, with no have returned a historical profit of 67.726 points but also would have produced a
drawdown during this period. nasty 21-point drawdown had we been without stop-loss provisions.
FIGURE 15: FAIR ISAAC, BOLLINGER (LONG ONLY) RESULTS. If we had taken FIGURE 16: IBM, BUY AND HOLD RESULTS. The best of the three methods
the long side only of our Bollinger/RSI trading rules, we would have had a historical historically, buy and hold would have returned a profit of 243.46 points with a very
profit of 50.663 points during this time. In this case, the account would not have reasonable five- or six-point drawdown early in the position.
experienced any negative account equity during this period, though three of the five
trades would have experienced small drawdowns.
buy and hold method. The longer a position is held, the more Figure 12 shows Fluor with only the long trades, which
likely it is that something will go wrong. returns a historical profit of 31.712 points and no negative
The short side only of our trading rules is shown in Figure account equity. However, two of the three trades do have
9 with quite a volatile equity line, even though the short side drawdowns before turning profitable, and the third has a
has a net profit of 12.325 points over this period. However, it significant one at that. But we are exposed to the market for
would be very hard to hold these short positions, given the much less time than buy and hold and the reward is also much
amount of drawdown shown in the equity line in Figure 9. greater as well. The short side of our Bollinger/RSI method
Let’s look at another example, this time of Fluor during the was even more profitable (34.113 points) than the long side.
same period. Figure 10 shows buy and hold with a net Another stock, Fair Isaac Co., can be seen in Figures 13,
historical profit of 2.025 points and a maximum negative 14, and 15, using buy and hold, Bollinger/RSI, and Bollinger/
equity of about seven points. Figure 11 shows Fluor during RSI-long only, respectively. The historical profits were 34.90
the same period, with trades shown using our Bollinger band/ for buy and hold, 67.726 for Bollinger/RSI (long and short),
RSI trading rules. This method had a historical profit of and 50.663 for Bollinger/RSI-long only. Of the three meth-
65.075 points, but there was a negative account equity of ods, only the Bollinger/RSI (long and short) method experi-
about 11 points, considerably more than buy and hold. enced a negative account equity line — a whopping 21 points,
FIGURE 17: IBM, BOLLINGER RESULTS. The trading rules would have returned FIGURE 18: IBM, BOLLINGER (LONG ONLY) RESULTS. Here, we see the long
a very dismal historical loss of 112.76 points. We can conclude that we do not have side only of our trading rules for IBM, returning a historical profit of 16.663 points.
the Holy Grail of trading methods, as the equity line above shows. 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.
thanks to the initial short position (Figure 14). We did not Chande, Tushar, and Stanley Kroll [1993]. “Stochastic RSI
have any stop-loss† provisions in our rules, and it is likely And Dynamic Momentum Index,” Technical Analysis of
that any viable trading system would stop out of the position STOCKS & COMMODITIES, Volume 11: May.
long before being anywhere near 21 points in the red. Edwards, Robert D. and John Magee [1992]. Technical
Finally, our last example in Figures 16, 17, and 18 show Analysis Of Stock Trends, John Magee, Inc.
IBM during the same time frame using the same trading Hurst, J.M. [1970]. Profit Magic of Stock Transaction Tim-
methods: buy and hold, Bollinger/RSI (long and short), and ing, Prentice-Hall.
Bollinger/RSI-long only. In these three examples, buy and Lapin, Lawrence L. [1987]. Statistics For Modern Business
hold was far superior, with a historical profit of 243.46 points, Decisions, Harcourt Brace Jovanovich.
compared with a loss of 112.76 for Bollinger/RSI long and Murphy, John J. [1996]. The Visual Investor, John Wiley &
short, and a profit of 16.663 for Bollinger/RSI long only. Sons.
Clearly, we have not discovered the Holy Grail of trading Star, Barbara [1993]. “RSI Variations,” Technical Analysis of
methods, and any method we use to trade requires sound STOCKS & COMMODITIES, Volume 11: July.
money management techniques, stop-loss provisions, and Sweeney, John [1997]. “The Relative Strength Index (RSI),”
extensive historical testing before risking any money. Technical Analysis of STOCKS & COMMODITIES, Volume
15: September.
CONCLUSIONS Wilkinson, Chris [1997]. Technically Speaking, Traders Press:
Does the fact that our rules didn’t produce a profit historically Greenville, SC.
for IBM imply that a trading method that includes Bollinger S&C
Bands and RSI isn’t worth considering? No. There is no †See Traders’ Glossary for definition
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 test-
ing of the markets you trade, money management, and last but
not least, your own personal trading style.