Bollinger Bands For Support And Resistance

08/18/00 03:50:34 PM

by David Penn

Prices that move beyond Bollinger bands often do so at their own peril as this look at Hormel suggests.

Security: HRL
Position: N/A

While trendlines are important tools in measuring support and resistance in price action, Bollinger bands provide a measure that is in many ways both more exacting and more flexible. Bollinger bands plot two standard deviations--one above and one below--from a 20-period moving average for the stock in question. When prices near the topmost Bollinger band, the stock is said to be testing resistance. When prices near the bottommost Bollinger band, the stock is said to be testing support.

One point about Bollinger bands is key, and helps further differentiate their utility from that of trendlines. Statistically speaking, by plotting a region two standard deviations in size, Bollinger bands encompass 95% of the data values that differ from the middle average (the 20-period moving average mentioned). For trading purposes, this means that prices that fall outside of the Bollinger bands are exceptional. Traders should be wary of following prices through and beyond a Bollinger band insofar as these aberrant price movements are corrected (and, occassionally, overcorrected) quite frequently. Another worthwhile point about Bollinger bands is that the bands themselves tend to widen when prices are volatile and to contract or narrow when volatility decreases, such as when prices fall into a consolidation or trading range. The longer the Bollinger bands remain contracted, the more likely the subsequent price move will be a dramatic one.

Note the contractions in the Bollinger bands in September - October 1999 and at the beginning of January 2000. Such contractions can anticipate greater price volatility

Graphic provided by: TradeCharts.

In the chart of Hormel [HRL] above, we note that HRL trended upward through 1999 almost entirely without a hitch. In fact, it is the absence of "hitch" or countertrend that makes the Bollinger band start to contract as the year unfolds, suggesting that HRL has become a great deal less volatile. By the time HRL gets to September, however, its near constant testing of the upper resistance Bollinger band has resulted in a few one or two point breakouts. Although small, these breakouts could have been read as the first few signals that the 1999 bull market for Hormel was about to intensify, become even more steep and continue climbing.

However, through September and October 1999, HRL was beginning to overstay its welcome in the low twenties. The narrowing of the Bollinger bands at that point, combined with the leveling off of the price and the inability of the price to close consistently above the upper Bollinger band, should have been cause for caution. And the prices's sudden swing in late December 1999 and early January 2000 to the lower support Bollinger band might have been cause for evacuation, as HRL lost over 40% of its value by March 2000. While an ordinary support trendline might have alerted an observant trader to the impending bearish turn, the narrowing or contraction of the Bollinger bands from June 1999 until the eventual downturn in January 2000 would have warned, at best, of a weakening trend and, at worst, of a trend that was unsustainable.

In some ways, the 20-day moving average upon which the Bollinger bands are placed acts as a sufficient, singular trendline, as well. An ordinary trendline connecting, for example, late November 1998, early January 1999 and July 1999 lows would intersect with HRL in mid-December 1999, right before the stock's major decline. However, the use of Bollinger bands would have warned of the upside price extremes in late September 1999 that anticipated the bearish correction in store for Hormel less than three months later.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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