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In the 1980’s a technical indicator named Bollinger Bands were created by John Bollinger. First let me describe how this indicator should appear on charts, then I will discuss how and why it plots the data it does, and finally how we can use this information to make great trade ideas.
Bollinger Bands may look different from one chart provider to the next. They may appear as two lines or as three. Assuming your chart only shows you two lines, one will be above the other. We will call these the upper and lower bands. In the instance where three lines are used, the center line should just be a moving average of the stock price.
If your chart only plots the upper and lower bands, I suggest you add a simple moving average to have the middle line. While it can be argued that the center line is unnecessary, I find it useful on occasions and more importantly it’s nice to have some uniformity with others who trade and teach the system you are learning.
This brings up a good point. A Bollinger Band can be set up with almost an infinite combination of settings, but we only want to use one: 20 period simple moving average, set on the close, with no offsets, measuring two standard deviations. Lucky for us, this should be the default setting. It may appear similar to this: “20-2” or “20, 2”.
Basically, the Bollinger Bands measure the “highness” or “lowness” of the price relative to previous trades. Think of the upper and lower bands as a moving bell curve if you will. The bell curve may have a broad or focused distribution, but you can visually see any outliers, whether the outliers are too low (below the lower band) or too high (above the upper band).
When the Bollinger Bands are far apart, this means that the past 20 days have been pretty volatile – a big discrepancy between the closing highs and the closing lows. When the Bands are close together, the past 20 trading days have been trading in a pretty tight range – with a very narrow discrepancy between the closes. The center of the Bollinger Band is the center of Distribution, a simple moving average.
Since two standard deviations will contain 95% of a data set, and by using a look back of 20 periods, we can multiply this out and get 19 “typical” closes and one “outlier”. Saying it another way; in the law of large numbers the Bollinger Band should have 19 closes inside the bands and one outside (either above or below).
I like to call this concept our “Lit Fuse” indicator. When the fuse is lit, you know that you’ll soon hear a boom, right? Same thing with this indicator. When a stock has spent a lot of time inside the Bollinger Bands, trading in a range, we know to expect a boom in the stock price – either up or down. If the stock doesn’t break out, it becomes more due. Often the longer the time contained inside the bands, the bigger the move out.
Notice our Lit Fuse indicator doesn’t tell us whether the boom will be up or down, just that something is going to go boom! So what does the Lit Fuse mean for us, trading options? It means that we can watch options move over 2,000% in one day!
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