Introduction
Bollinger Band Width is an indicator derived from Bollinger Bands. In his book, Bollinger on Bollinger Bands, John Bollinger refers to Bollinger BandWidth as one of two indicators that can be derived from Bollinger Bands. The other indicator is %B.
Non-normalized BandWidth measures the distance, or difference, between the upper band and the lower band. BandWidth decreases as Bollinger Bands narrow and increases as Bollinger Bands widen. Because Bollinger Bands are based on the standard deviation, falling Bandwidth reflects decreasing volatility and rising Bandwidth reflects increasing volatility.
SharpCharts Calculation
(Upper Band - Lower Band)
Bollinger Bands consist of a middle band with two outer bands. The middle band is a simple moving average usually set at 20 periods. The outer bands are usually set 2 standard deviations above and below the middle band. Settings can be adjusted to suit the characteristics of particular securities or trading styles. BandWidth is simply the difference between the upper band and the lower band.
The chart above shows the S&P 500 ETF (SPY) with Bollinger Bands, Bandwidth and the Standard Deviation. Notice how Bandwidth tracks the Standard Deviation (volatility). The image below shows a spreadsheet with the calculations for June 2009.
Defining Narrowness
It is important to remember that non-normalized BandWidth varies according to security's volatility and price. For reference, normalized Bandwidth divides the difference in Bollinger Bands by the middle band. A Bandwidth value of 5 would be considered narrow for $100 a stock, but wide for a $30 stock. Five is 5% of 100, but 16.6% of 30. Usually, Bandwith is considered low (narrow) when it is 5-10% of a security's price. Low BandWidth for a $50 stock would range from 2.5 to 5, while low Bandwidth for a $20 stock would range from .50 to 1. Depending on underlying volatility, the definition of narrowness may vary from stocks to stock. Bandwidth for Google (GOOG) will be generally high than Bandwidth for Consolidated Edison (ED), which is a utility.
Narrow Bandwidth can also be gauged relative to prior Bandwidth values over a period of time. It is important to get a good look-back period to define Bandwidth range. For example, a one year chart will show Bandwidth highs and lows over a significant timeframe. Bandwidth is considered narrow as it approaches it the lows of its one year range and high as it approaches the highs of its range.
Signal: The Squeeze
Bollinger BandWidth is best for identifying The Squeeze. This occurs when volatility falls to a very low level, as evidenced by the narrowing bands. The upper and lower bands are based on the standard deviation, which is a measure of volatility. Therefore, volatility contracts as the bands narrow. The bands narrow as price flattens or moves within a relatively narrow range. The theory is that periods of low volatility are followed by periods of high volatility. Relatively narrow BandWidth (a.k.a. the Squeeze) can foreshadow the start of a new advance or decline. After a Squeeze, a price surge and subsequent band break signal that a new move has started. A new advance starts with a Squeeze and subsequent break above the upper band. A new decline starts with a Squeeze and subsequent break below the lower band.
Chart 2 shows Alaska Airlines (ALK) with a squeeze in mid June. After declining in April-May, ALK stabilized in early June as Bollinger Bands narrowed. BandWidth dipped to around 1.5 to put the Squeeze play on in mid June. With the stock around 15-16, BandWidth was less than 10% of the stock price. With the subsequent surge above the upper band, the stock broke out to trigger an extended advance.
Chart 3 shows Aeropostale (ARO) with a couple of Squeezes. The second Squeeze occurred in October as ARO consolidated around 43 and BandWidth dipped below 3. Aeropostale is priced higher than Alaska Airlines and this means its non-normalized BandWidth will be relatively higher. Low Bandwith for ARO is below 4. Relatively low BandWidth in ARO alerted traders to be ready for a move in mid August. ARO subsequently broke the lower band with a move below 40 and this triggered an extended decline. The advance stalled in late September and BandWidth narrowed in October. Notice how BandWidth declined back to its August lows in early October and then flattened out. The subsequent break below the lower Bollinger Band triggered a bearish signal in late October.
The Squeeze can also be applied to weekly charts or longer timeframes. As expected, band breaks can take longer to materialize. Chart 4 shows Barrick Gold (ABX) consolidating throughout 2006 and into 2007. As the consolidation narrowed and a triangle formed, Bollinger Bands contracted and BandWidth dipped below 5. Notice how Bandwidth remained at low levels as the consolidation extended. A bullish signal triggered with the breakout in July 2007. BandWidth also rose as prices moved sharply in one direction and Bollinger Bands widened.
Chart 5 shows Honeywell (HON) with an extended trading range around 55. There was a move to the upper band in May, but no breakout for a signal. Instead, HON clearly broke below the lower band to trigger a bearish signal.
Conclusions
The Bandwidth indicator can be used to identify the Bollinger Band Squeeze. This alerts chartists to prepare for a move, but direction depends on the subsequent band break. A Squeeze and break above the upper band is bullish, while a Squeeze and break below the lower band is bearish. Be careful for head-fakes though. Sometimes the first break fails to hold as prices reverse the move the other way. Strong breaks hold, but weak breaks are challenged. An upside breakout followed by an immediately pullback should serve as a warning.
Source:http://stockcharts.com/
