How to Use the Bollinger Band Width Indicator to call Major Tops and Bottoms
The Bollinger Bandwidth indicator is derived from the famous Bollinger bands and its corresponding values. The Bollinger Bandwidth or BBW for short was first outlined by John Bollinger in his book, Bollinger on Bollinger Bands.
It was in this book that John Bollinger introduced the Bandwidth indicator including the %B (called as percent B) indicators which are the two indicators that are based along with Bollinger bands and the values of the indicator that it represents.
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Among a number of different technical indicators available, the Bollinger bands are one of the most widely used technical indicators when it comes to measuring market volatility.
The bands are comprised of two lines which envelope price and are plotted at two standard deviation levels away from the 20-period simple moving average (SMA). In a way, the Bollinger bands not only measure volatility but also trends based off the 20-period simple moving average.
This gives the default setting of the Bollinger bands at 20, 2 and visually the Bollinger bands are identified by the three lines on the price chart. When volatility increases, the bands tend to expand and when volatility decreases, the Bollinger bands contract, giving it the classic Bollinger band squeeze and expansion.
This gives them the name Rubber bands as the bands tend to expand and contract reflecting volatility in the security and are very flexible. Strong trends are signaled when price breaks one of the bands and continues in the direction, to which the Bollinger bands automatically adjust to. This is also referred as walking the bands.
Similarly, one can expect to see a pullback when volatility fades by the time price reaches one of the upper or the lower Bollinger band.
The chart below shows an example of the standard Bollinger bands applied on the SPY ETF daily chart with the default settings of 20,2. One can of course choose the values that suit the security the best. Some of the common Bollinger band settings include three standard deviations for a 20-period SMA as well.
As with any technical indicator, testing different parameters are ideal to fine tune the responsiveness of the indicator being used.
The Bollinger bandwidth indicator measures the percentage difference between the upper and the lower bands. The bandwidth indicator is actually an oscillator and is plotted on the sub-chart or a sub-window.
As and when volatility expands and contracts, thus resulting in the Bollinger band squeeze and expansion, the Bollinger bandwidth indicator decreases and increases in value, all the time oscillating between the fixed values.
The next chart below shows the Bollinger bandwidth indicator applied to the chart. In most cases, the Bollinger bandwidth indicator is used alongside the Bollinger bands.
In the above chart the Bollinger band is used to visually show how the bandwidth indicator reacts accordingly. When the distance between the two outer Bollinger bands contract, the Bandwidth indicator falls and when the upper and the lower Bollinger bands expands, the Bandwidth indicator rises.
Due to the fact that Bollinger bands are based on standard deviation of the 20-period SMA the Bollinger bandwidth indicator reflects rising and falling volatility, depicted as an oscillator that moves between fixed values.
The benefit of using the Bollinger bandwidth indicator is that it provides an easy way to visualize the price consolidation (low bandwidth values) signaled by the Bollinger band squeeze and periods of volatility (high bandwidth values) signaled by the Bollinger bands expansion.
The Bollinger bandwidth indicator does not use any special values and is based upon the standard settings of the 20 period SMA and the two standard deviation values.
How does the Bollinger Band width indicator work?
The Bollinger Bandwidth oscillator measures the difference in values between the upper and the lower bands. The resulting value is then divided by the mid-band or the 20-period simple moving average.
The Bollinger bandwidth as an oscillator rises and falls reflecting the increase and decline in the volatility. When volatility increases, the Bollinger bandwidth rises and when volatility decreases, the Bollinger bandwidth declines or falls.
With Bollinger bands, it is a well known fact that when the upper and lower bands are relatively far apart, it indicates that the current trend could be ending or possibly signaling a pull back to the trend. Likewise, when the upper and lower Bollinger bands tighten or narrow, it signals that a possible strong move in the market is likely to occur.
The chart below shows some examples of the Bollinger bandwidth indicator and the following volatile move in the market.
The above chart shows how the lows formed on the Bollinger bandwidth signaled a potential strong move in the markets. In the first stance, the low period of consolidation was marked by a strong breakout in prices.
In the second scenario, the low period of volatility, marked by the Bollinger bandwidth indicator at the low and price near a short term top coincided by a strong decline in prices. This decline was later marked by the end of volatility with the Bollinger bandwidth indicator marking a high.
Finally, the third example shows prices near the high with the Bollinger bandwidth at the lows and the resulting decline in prices.
As you can see the peaks and troughs formed by the Bollinger bandwidth signal the rise and fall of volatility and this reflects the short term gains and declines in prices.
According to John Bollinger, the fall in the Bollinger Bandwidth indicator below 2% or 0.02 has led to many big moves in the S&P500 index. The chart below shows this example, where one can see that the market tops coincided closely with the Bollinger bandwidth indicator falling below the 0.02 or 2% threshold.
You can see how in all the three instances, price fell 5.6%, 3.6% and 7.6% approximately off the short term market tops.
However, Bollinger also cautioned that in most cases, price begins by making a false breakout often trapping weak positions near the top before making the strong declines or correction in price.
How to calculate the Bollinger bandwidth
Calculating the Bollinger bandwidth indicator is very simple. The first step is to subtract the values of the lower band from the upper band. This shows the difference or the price range, so to speak. This difference is then divided by the value of the middle band which is the 20-period SMA.
The result is therefore a normalized bandwidth value which can be compared to the different timeframes.
Mathematically, the Bollinger bandwidth is calculated as follows:
Trading with the Bollinger bandwidth indicator
The most common way to trade with Bollinger bands or any indicator to do with volatility is of course breakouts. Because breakouts usually occur after prices move in a sideways range, they make for the ideal set ups to trade with volatility indicators such as the Bollinger bands as well as the Bollinger bandwidth indicator.
While there are relatively limited indicators when it comes to measuring the volatility, the Bollinger bandwidth indicator measures the strength of the trend. In a way, the Bollinger bandwidth indicator can be used to not just spot the breakouts in prices but also as a trend strength indicator.
As a trend strength indicator, the Bollinger bandwidth can work as an effective tool to signal when a trend is likely to end.
However, an important distinction to make here is that the rise and fall of the Bollinger bandwidth indicator could mean either the change of the trend or the short term corrections within the trends.
In the following chart, we have the SPDR S&P500 SPY ETF intraday chart. Here we can see that while prices posted a low it was marked by a low in the Bollinger bandwidth. This potentially indicated that a possible breakout was in the making.
However, remember that the Bollinger bandwidth indicator is not a trend direction indicator but only measures volatility.
Following the low in price, as the Bollinger bandwidth indicator starts to rise (indicating that volatility was also rising), we can see that price starts to post a steady increase as well.
The next low that was formed signaled a short term minor consolidation in price, which was nothing but a sideways range rather than a pullback in prices. As volatility continued to move at a gradual pace, price continues to keep up the uptrend.
In most cases, the Bollinger bandwidth indicator is ideally used alongside the Bollinger bands indicator as both these can complement each other. However, traders should note that the Bollinger bandwidth indicator merely does not tell you when the bands expand and contract, but can signal the extreme points in the volatility.
In the following chart the extreme values in the Bollinger bandwidth indicator signals the temporary peaks and troughs in prices. While the Bollinger bandwidth tends to oscillate and continues to form highs and lows, it is important to make the distinction of the extreme peaks and troughs that are formed by this indicator.
One of the unique characteristics of the Bollinger bandwidth indicator is that it not only signals the market tops and bottoms but also signals when one can expect to see a continuation or a reversal to the previous trend.
For example, in the first instance, the market bottom was signaled by a top in Bollinger bandwidth indicator. This top in the Bollinger bandwidth was one of the extremes, no matter which way one looks at it.
Likewise, the next market top that was formed was signaled by an extreme low in the Bollinger bandwidth indicator. In this instance, the market reversed direction and fell sharply (as denoted by the down gap that was formed in prices).
Traditionally, the Bollinger bandwidth indicator is said to signal a trade entry when the indicator falls to a historic low and starts to rise. This often signals a rise in volatility and depending on whether prices are at the peak or the trough they can set out on a new trend.
As shown in numerous examples above, the markets tend to move around and depending on whether a high or a low is formed in price relative to a rising Bollinger bandwidth indicator, the appropriate long or short positions can be taken.
However, as with most technical indicators in trading, using the signals from just one technical indicator can be disastrous as indicator signals when taken in isolation could lead to potential fake signals that could result in trading losses.
While the Bollinger bandwidth indicator is a versatile indicator that does a very good job in measuring volatility, trading solely based off the signals from the Bollinger bandwidth indicator is not a good trading strategy.
Due to the fact that the indicator focuses on measuring volatility, traders can look at adding other indicators such as moving averages as well as making use of support and resistance levels on the price charts in order to confirm the signals from the Bollinger bandwidth indicator and trade accordingly.
In most cases, the declines or the dips in price tends to coincide with a 50 or a 200 period moving average, which is a strong support level off which long positions can be taken, especially when it comes to the equity markets or ETF’s such as the SPY.
To conclude, the Bollinger bandwidth indicator alongside the Bollinger bands are two unique technical indicators that can given insights about the volatility in the markets. When used correctly, the Bollinger bandwidth indicator can be a great way to day trade the stock markets by picking the short term tops and bottoms in the price.
Traders can also go a step further and confirm these tops and bottom with other indicators such as volumes, or other tools such as the CBOE Volatility Index which is also another widely used indicator for market volatility.