In the last article we looked at Moving Averages. In Part 11, we take the evolution of direct price analysis, in technical analysis, a step further in its application. In this article we are looking at ‘bands’ created around price, for the purposes of trade management and identifying trading opportunities. We are going to look at four of my favourites: Bollinger Bands, Donchian Bands, Keltner Bands and Envelopes.
Why use bands?
Price bands plot a price range around the original price, above and below. They overlay the price on the chart. This range can be based on percentages, statistical measures, volatility etc. These bands will move and adjust with the flow of the price. A band will help the analyst better determine if the trend is likely to be broken; if it is continuing within the band, it can offer statistical measures of where to possibly place your stops or take your profits. These tools can be used as trading systems by themselves; however, I find they work better in collaboration with other technical tools and approaches. The four we are going to look at are arguably the most commonly used in technical analysis:
These bands encapsulate the volatility of the underlying instrument. They were created by John Bollinger and use a statistical concept to capture price movement. By default, the tool plots 2 standard deviation bands away from a 20 period moving average. Because of this set up, it tells the user that between the two bands, 95% of the ‘normal’ price action should occur. When markets become more volatile, the bands widen and when less volatile, they shrink. The inputs – the standard deviations and moving average length – can be adjusted for the purposes and objectives of your analysis and trading.
Some trading thoughts for Bollinger Bands:
- Price that hits +/- 2 standard deviations can signify price reversals back to the mean moving average.
- Bands are better used to determine the beginning of a trend rather than trading between them. Trading between the bands on first glance looks the obvious solution, but this can be tricky.
- A breakout from the bands that contains approx. 90% of previous price action suggests the general trend of the previous price action has changed in the direction of the breakout.
- When bands tighten, this can often signify an explosion in price going forward – use other indicators to line up the direction of the explosion.
- If your charting package allows, try offsetting the bands for more obvious breakouts.
An example using Vodafone PLC (Charts: Stockopedia) applying Bollinger Bands to the chart:
Remember the film ‘Trading Places’ staring Eddie Murphy? The film was actually based on the true life story of the legendary trading Turtles*. One of their most successful strategies was to use Donchian bands. Devised by Richard Donchian, he created the famous 4 week breakout system aka the Donchian method.
The system only requires the recording of highs and lows over a user-defined period. By default, this period is usually set to 20 periods. The system establishes bands that plot these highs and lows. Donchian’s system was quite straight forward:
- A buy, or long, signal is created when the price action > the highest level over the last 4 weeks (20 days)
- A sell, or short, signal is created when the price action < the lowest level over the last 4 weeks (20 days)
Some charting packages allow you to offset the price action, which can allow for more definitive signals.
Using Vodafone PLC (Charts: TradingView) with Donchian bands included:
Keltner Bands (aka ATR bands)
Like Bollinger, Chester Keltner introduced the concept of price volatility into his indicator. He did this by using an ATR (Average True Range) on a 10 day moving average. The bands are created by making a 10 day moving average of the High minus the Low or bar range.
- The upper band: 10 day moving average of price + 10 day moving average of bar range.
- The lower band: 10 day moving average of price – 10 day moving average of bar range.
Again, like all these tools, the inputs can be varied to suit.
Vodafone PLC (Charts: TradingView) with a 10 period Keltner Band applied:
A very simple approach for creating bands is by using the envelope, especially if you have a good feel for the price action of whatever you are analysing. One approach is the Percentage envelope. It works by taking a set percentage (user defined) of the moving average and adding / subtracting this to the moving average, to give your band range. Popular percentage inputs are 1%,2%,3% but this can depend on your time horizons and what you are trading.
In terms of application, it is often used as a breakout system when prices either break to the up or downside. Some trade within the bands – especially if a market is ranging. Its obvious flaw is that it doesn’t take any consideration of the volatility of what’s being analysed – so a 1% percentage band, for example, can not be uniformly applied to your trading.
Vodafone PLC (Charts: TradingView) with a 20 period, 3% envelope applied:
Further reading and learning:
If you are interested in learning more about bands, then the following reading may help:
- *Way of the Turtle, The Secret Methods that turned Ordinary People into Legendary Traders, Curtis M Faith, McGraw-Hill, 2007.
- Technical Analysis of the Financial Markets, John J Murphy, New York Institute of Finance, 1985.
- Technical Analysis, The Complete Resource for Financial Market Technicians, Charles D Kirkpatrick, FT Press, 2006.
Bands can be a very useful tool to capture the volatility, trend and range of an instrument. They can make effective stand alone trading strategies and provide extra analysis for your trade management processes. Results from using these tools can be further enhanced by marrying them up with non-related technical analytical tools.
Next time: Technical Analysis (Part 12): Direct Price Analysis (DPA) – Trending or Ranging?