In this chart I have stripped away everything except the
candlesticks showing daily trades, trading volume, and Bollinger Bands.
Before I explain why this is significant, let me offer you
the caution that the underlying asset here – an ETF covering calls on the
Canadian banks – is risky, and fees can be high. To understand the risks,
please click on the attachment.
Bollinger Bands consist of a centre line and two price
channels (bands) above and below it. The centre line is an exponential moving
average; the price channels are standard deviations of the stock under study.
The bands expand and contract as the price action of an issue becomes
volatile (expansion) or becomes bound into a tight trading pattern
(contraction).
In the 1980s, John Bollinger, a long-time market
technician, developed the technique of using a moving average with two
trading bands above and below it. Unlike a percentage calculation from a
normal moving average, Bollinger Bands simply add and subtract a standard
deviation calculation – essentially, a mathematical formula that measures
volatility, showing how the stock price can vary from its “true value.” In
2001 he published an excellent book on the system, titled Bollinger on
Bollinger Bands. You can download it as a PDF here.
Bollinger considers his eponymous instrument as the
primary tool in a system he calls “rational analysis.” That system, he says,
combines “technical analysis and fundamental analysis in a relative
framework.”
By measuring price volatility, Bollinger Bands adjust
themselves to market conditions. This is what makes them so handy for
traders: they can organize relevant price data between two bands in such a
way that they give you a sense of when to sell, and when to buy. Selling when
the asset is close to the top band makes sense. Similarly, if you like an
asset, you should buy when it’s close to the bottom.
Of course, nothing in this note in any way constitutes a
buy-or-sell recommendation.
