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BOLLINGER ON BOLLINGER BANDS
By John Bollinger
McGraw-HillCopyright © 2002 The McGraw-Hill Companies, Inc.
All right reserved.
Over 80 years ago, the physicist Albert Einstein introduced his concept of relativity. At its core, relativity suggested that all things existed only in relation to one another. The inevitable conclusion is that nothing stands alone—there are no absolutes. For there to be black there must be white; fast exists only in relation to slow; a high cannot exist without a low for reference; etc. Einstein applied his theories to physics and in doing so lost a wider audience to whom those theories might have appealed. However, others such as the philosopher Bertrand Russell, were at work extending similar ideas beyond physics.
In a serialized form of his book [The ABC of Relativity] that appeared in The Nation during 1925, Russell expressed the belief that once people had become used to the idea of relativity it would change the way they thought: people would work with greater abstraction and would replace old absolute laws with relative concepts. This has certainly happened in the world of science but the absorption of relativity into popular culture has done little to change the way most people think, simply because very few have got used to relativity or understand it in the least.
At about the same time Einstein was starting his work, Oliver Wendell Holmes, Jr., a U.S. Supreme Court justice, was engaged in pushing our nation's system of justice in the direction of relativity. He suggested that the courts could not determine absolute truth. They could only judge the relative merits of the competing claims before them, and they could not do so in an absolutist framework, but only in a framework relevant to society. Early in his career Holmes stated:
The law embodies the story of a nation's development through many centuries, and it cannot be dealt with as if it contained only the axioms and corollaries of a book of mathematics. In order to know what it is, we must know what it has been, and what it tends to become.
The work of Einstein and Holmes didn't stand alone. Their focus was an indication of an emerging trend within society. Since the world was starting to become more complex as the nineteenth century drew to a close, it was widely realized that the absolute truths that had governed the affairs of people would no longer serve, that a relative framework would be needed if progress were to continue—and so it is with the markets.
Such ideas are humble in their essence. They recognize our limits. They reflect Eastern rather than Western philosophy. The goal of the perfect approach to investing is just that, a goal. We may approach it, but it always will elude our grasp. Indeed, there is no perfect system. We can only do as well as we can within our limitations, at the urging of our potential.
Benoît Mandelbrot discovered nonlinear behavior in cotton prices in his early research into chaos. Others have followed who suggested that financial systems are in fact extremely complex, so complex that they exhibit hard-to-predict behavior similar to the best-known complex system, the weather. As systems become more complex, traditional linear analytical tools fail, and it becomes ever harder to understand them. The only tools that serve to help understand complex systems are relative tools.
It is not the purpose of this book to plumb the depths of the arguments, pro or con, regarding these matters. Rather, we accept the weight of the evidence that prices are not distributed normally and markets are not the simple systems that most people think they are. Our base assumption is that the markets are systems of increasing complexity that are ever harder to master.
The old saw suggests that in order to make money in the market, you must buy low and sell high—or vice versa. As the markets have become more volatile and the patterns more complex, this has become increasingly harder to do. There is a fable from the trading pits in Chicago where the most active of the world's futures contracts are traded. It suggests there is a god who rules the pits. This god has but two rules: One, you may buy the bottom tick—once in your life. Two, you may sell the top tick—again, once in your life. Of course, by implication you are free to do the opposite as often as you would like.
The purpose of this book is to help you avoid many of the common traps investors get caught in, including the buy-low trap where the investor buys only to watch the stock continue downward, or the sell-high trap, where the investor sells only to watch the stock continue upward. Here, the traditional, emotional approach to the markets is replaced with a relative framework within which prices can be evaluated in a rigorous manner leading to a series of rational investment decisions without reference to absolute truths. We may buy low, or sell high, but if we do so, we will do so only in a relative sense. References to absolutes will be minimized. The definition of high will be set as the upper trading band. The definition of low will be set as the lower trading band. In addition, there will be a number of suggestions to help you tune this framework to your individual preferences and adjust it to reflect your personal risk-reward criteria.
Part I starts with this chapter, the introduction. Then, in Chapter 2, you'll read about the raw materials available to the analyst. Next in Chapter 3, you'll learn how to select the proper time frames for your analysis and how to choose the correct length and width for Bollinger Bands. In a more philosophical vein, Chapter 4 looks at the contrasting approaches of continuous advice versus the process of locating setups that offer superior risk-reward opportunities. Part I concludes with a discourse, in Chapter 5, on how to deploy successfully the ideas you will read about in this book.
Part II covers the technical details of Bollinger Bands. It begins with Chapter 6, on the history of trading bands (and in Chapter 20 in Part IV we reprise the oldest trading system known to us based on trading bands). Chapter 7, which describes the construction of Bollinger Bands, follows next. Chapter 8 is devoted to a discussion of the indicators that are derived from Bollinger Bands: %b, a method of mathematically determining whether we are high or low, and BandWidth, a measure of volatility. We close Part II with Chapter 9, which discusses volatility cycles, surveys some of the academic ideas that support the concept of Bollinger Bands, and reviews the relevant statistical issues.
If you are not interested in knowing the details behind the tools, you may want to skip Part II and go straight to Part III, where the discussion of how to use Bollinger Bands begins. While Parts III and IV build on the foundation laid out in the first two parts, you can read them independently.
Part III explains the basic use of Bollinger Bands. It starts with Chapters 10 and 11 on pattern recognition and introduces Arthur Merrill's M and W pattern categorization. Then Chapters 12 and 13 tackle the use of Bollinger Bands to clarify the most common trading patterns, with W bottoms covered in Chapter 12, and M tops explored in Chapter 13. The trickiest phase, "walking the bands," is taken up next, in Chapter 14. Finally there are two related chapters on volatility. Chapter 15 describes The Squeeze—with some examples for the stock and bond markets. Then Chapter 16 provides the first of three simple methods that illustrate the rigorous use of Bollinger Bands, a volatility-breakout system rooted in The Squeeze. Part IV adds indicators to the analytical mix. It focuses on coupling bands and indicators in a rational decision-making framework. Chapter 17 offers a general discussion of coupling indicators and bands. Chapter 18 follows with a discussion of volume indicators, including those that are best suited for use with Bollinger Bands. In Chapter 19 and 20, we focus on combining price action and indicators in two rational decision systems using %b and volume oscillators—one system that follows trends and one that picks highs and lows.
Part V focuses on a couple of advanced topics, such as normalizing indicators with Bollinger Bands (Chapter 21) and techniques for day traders (Chapter 22), who are making increasing use of Bollinger Bands.
In Part VI, we summarize the major issues regarding Bollinger Bands via a list of rules and offer some closing thoughts.
Endnotes follow Part VI. Where I have had tangential thoughts that were important but that might interrupt the flow of the chapter, they have been included in the Endnotes. There is much of value in those notes and so be sure to check them out. The Endnotes also include references for material cited in the chapters.
The three trading methods presented in Parts III and IV are anticipatory in nature. Method I uses low volatility to anticipate high volatility. Method II uses confirmed strength to anticipate the beginning of an uptrend or confirmed weakness to anticipate the beginning of a downtrend. Method III anticipates reversals in two ways: by looking for weakening indicator readings accompanying a series of upper band tags or by looking for strengthening indicator readings accompanying a series of lower band tags. More dramatically, Method III also looks for nonconfirmed Bollinger Band tags, a tag of the lower band accompanied by a positive volume indicator or a tag of the upper band accompanying a negative volume indicator.
And now we turn our attention to jargon—you can't live with it and you can't live without it. Many years ago a new hotshot executive type at the Financial News Network, who came from radio and knew nothing of finance, declared that upon each and every use of jargon the presenter had to stop and define the term. He had a point. The terminology we used needed to be defined upon occasion, but not compulsively enough to halt the flow of content. A book allows for a convenient place where jargon can be slain, a Glossary. A lot of work went into keeping the use of jargon to a minimum and into the Glossary, so if you stumble across an unfamiliar term that is undefined in the text, or an unexpected usage, just turn to the Glossary and you'll most likely find the definition. The Glossary serves another purpose too. In many cases investing terminology is poorly defined. Terms may have more than one sense or multiple meanings, all of which can be confusing. In the Glossary the sense of the terms as used here is laid out.
The book closes with a Bibliography—really more of a suggested reading list that is closely coupled to the subject matter at hand. It is not meant to be a scholarly cross-reference to the literature; rather it is a useful guide to readily accessible relevant books. Most of the books should be available in your library or easily obtained from your favorite financial bookseller.
I have included a handy reference card for your convenience. It's bound into the back of the book. The basic Bollinger Bands rules are set out on the front of the card, the inside presents the M and W patterns, and the back presents the most important formulas. Tear it out and use it for a bookmark while you read. Then keep it by your computer so it is handy when you do your analysis.
Finally, we have built a Web site, BollingeronBollingerBands.com, to support Bollinger on Bollinger Bands. There you'll find daily lists of the stocks that qualify for each of the three methods presented here and a screening area where you can screen a large universe of stocks based on any of the criteria from this book. There is great charting, a community area where you can discuss the issues and ideas related to Bollinger Bands, and links to our other sites as well.
Upon finishing this book you will have at your disposal a set of tools and techniques that allow you to evaluate potential and actual investments and trades in a rigorous manner. This is an approach that allows you to eliminate much of the emotion surrounding the investing/trading process and therefore allows you to reach your true potential as an investor/trader.
Chapter TwoTHE RAW MATERIALS
The market technician has a relatively small data set to work with, primarily price and volume. The data is reported for a chosen period—the high of the day, the low of the week, the volume for the hour, and so on. Typically the data comes in the form of date (time), open, high, low, close, and volume (see Table 2.1). The close is the most often consulted piece of data, followed by the high and low, then volume, and, last, the opening price. In June 1972, Dow Jones removed the opening prices from the Wall Street Journal in order to expand its listings and has never put them back. So several generations grew up without access to the open. Fortunately, with the advent of electronically distributed data, the open has again become widely available in the United States and is being used after a long period of neglect.
These basic data elements can be combined in a variety of ways to form the charts that traders and investors typically use. There are four types of charts of significance: the line chart, the bar chart, the candlestick chart, and the point-and-figure chart. The line chart is the simplest of all, offering an outline of price action. The bar chart is the chart of choice in the West, usually drawn without the open or volume. Candlestick charts, which are rapidly gaining acceptance in the West, come from Japan, where they are the charting method of choice. Point-and-figure charts depict price action, pure and simple, and are perhaps the oldest of Western technical charting techniques.
Charts may be created for any time period: 10 minutes, hourly, daily, weekly, etc. Years ago the primary chart types were daily, weekly, and monthly. Hourly, daily, and weekly charts became the popular choice in the 1980s, and the trend has continued toward ever-shorter time periods, with tick charts that display each trade as well as five-minute and shorter charts enjoying ever-increasing greater popularity.
Most charts display price on the vertical, or y, axis, and time on the horizontal, or x, axis. But that is not always the case. EquiVolume charts—invented by Edwin S. Quinn and popularized by Richard Arms of Arms Index fame—depict volume on the x axis. Point-and-figure charts depict the number of price swings in excess of a given value on the x axis.
Line charts simplify the action greatly by taking a connect-the-dots approach and connecting the closes to render a sketch of the action. Line charts often are used for clarity when a great deal of data must be displayed and bar charts or candlesticks would be too cluttered. They also are used when only a single point is available for each period, such as the daily advance-decline line or a value for an index calculated just once a day, as shown in Figure 2.1.
A conventional bar chart, shown in Figure 2.2, consists of a vertical line connecting the high and low with a horizontal tick to the left at the open and another horizontal tick to the right at the close. When volume is included, it is usually plotted in a separately scaled clip beneath the price clip as a histogram rising from a baseline of zero. Each volume bar records the volume of trade during the period depicted by the price bar immediately above it. (Often the last two—or more—digits of volume are omitted.)
Japanese candlestick charts place a greater emphasis on the opening and closing prices than do bar charts. This is accomplished by drawing a narrow vertical box delineated by open and close—the main body. The body is filled in (black) if the close is lower than the open; otherwise it is left empty (white). From the top and bottom of the box, thin line segments—the shadow lines—are drawn to the high and low of the day if these points are outside the box, as seen in Figure 2.3. I have employed candlestick charts for many years and prefer them to bar charts; they create a clearer picture for me.
Bollinger Bars (Figure 2.4) were created in an effort to combine the advantages of both bar and candlestick charts. Bollinger Bars are a cross between bar charts and candlestick charts, where the portion of the bar between the open and the close is colored red if the close is lower than the open or green if the close is higher. The remainder of the bar is colored blue. These bars have the benefit of highlighting the important relationship between the open and close without taking up the extra space the candlesticks require. Bollinger Bars can be seen in action on EquityTrader.com.
Excerpted from BOLLINGER ON BOLLINGER BANDS by John Bollinger Copyright © 2002 by The McGraw-Hill Companies, Inc. . Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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