Bollinger Bands (Part II of IV)

03/14/01 11:12:42 AM

by Dennis D. Peterson

Bollinger bands are one of the most successful indicators available today.

Security: AOL
Position: N/A

Since most sites choose RSI as the indicator to use with Bollinger bands, I will start there. Suppose I wrote a simple trading system for long positions only. For long positions, I want to ride the upper band walkers as they increase in price and get off quickly, being mindful of whipsaws. Upper band walkers are those prices that are nearly touching, or greater, than the upper band. I will use RSI as a confirming indicator. As long as RSI holds to a certain value, it will confirm the price gain of upper band walkers.

The rule for upper band walkers is to have the closing price be within a fixed amount (optimized using Metastock system tester) of the band width. The formula for entry is:

Abs((close-Bollinger band top) /Bollinger bandwidth) < optimized value,

RSI > optimized threshold value,

using closing price.

The exit is created by using the same formula for Bollinger but RSI less than an optimized value,

Abs((close-Bollinger band top) /Bollinger bandwidth) < optimized value,

RSI < optimized threshold value,

using closing price.

After optimization, the period chosen for RSI was 28 days, and for entry and exit the optimized threshold value was 48. The optimized value for the amount of the close to be next to the upper band, as fraction of bandwidth, was 0.2. Before I created the system test, I created the custom indicator for measuring the closeness of the closing price to the Bollinger band top and what I observed was about 0.2 as well.

Figure 1: AOL volume and price (bottom and middle charts), and equity performance (top chart: using semi-log scale) using RSI alone, and RSI with Bollinger bands. An initial investment of $1,000 was made in 1996.

Graphic provided by: MetaStock.

Graphic provided by: Data vendor: eSignal<.

I also wrote a trading system that used RSI alone. Starting with $1,000 in 1996, it's apparent that this system ends up with more equity. But would you choose RSI alone rather than Bollinger bands and RSI? I would say RSI with Bollinger bands is the preferred choice. Why?

Starting in 1996, AOL's gradual run-up builds an equity holding that can take serious losses and still come out ahead. Suppose you didn't start in 1996. Suppose you started in mid-1999. Using RSI alone, you would probably not be a happy camper. Using Bollinger bands in conjunction with RSI gives steady growth with much less serious drawdowns, no matter when you start your investment. Taking long positions only with a stock that is going down (AOL - early 2000 and on) you would not expect to make any gain, but with Bollinger bands used in conjunction with RSI you still manage to make a modest capital gain.

What I do about commissions in these calculations? I don't do anything. Suppose you started with $10 and invested in a stock that cost $10 and it went up to $20. Suppose the commission for buying and selling was $30 for each trade. That's $60 in commissions for a $10 gain, so even though your stock doubled, you are in the hole for $50. Suppose you bought 1,000 shares instead of one. Then you would have invested $10,000 and made $10,000 in profit. Does $60 really matter? Obviously not. What you want is an investment strategy that allows you to be indifferent to commissions, which generally means trading larger amounts with fewer trades. With more at risk can you stand substantial drawdowns? No, because you are risking more. This is not to say you don't want commissions to be low, but that commission-driven systems are more a daytrading concern which can easily see 20 or more trades in a week than they are for trading systems that trade 100 times over several years. That's why I am concerned about drawdowns (so are daytraders - but they are also concerned about commissions).

I also have plotted the equity growth using semi-log because I wanted to compare the rates of growth between RSI and Bollinger bands using RSI. The major difference is in the period leading up to 1999. If you had known AOL was going up for years starting in 1996, buy-and-hold would have worked well, and Bollinger bands and RSI would be just an academic exercise. It is performance during volatile times that becomes a better test of how well a system (such as buy-and-hold) performs. What can be seen is that the two (Bollinger bands using RSI and RSI alone) have the same growth rates at times, except that using RSI alone can make bigger moves up at the expense of bigger drawdowns.

Here are the results for the two:

RSI

Total winning/losing trades: 71/80
Largest win/loss: $10,450/$2,950
Most consecutive wins/losses: 7/8

Bollinger bands and RSI

Total winning/losing trades: 40/28
Largest win/loss: $1441/$520
Most consecutive wins/losses: 5/3

Dennis D. Peterson

Market index trading on a daily basis.

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