Technical Analysis, Studies, Indicators:
Bollinger Bandwidth is based on the Bollinger Bands indicator, which was developed by John Bollinger. Bandwidth is used in technical analysis to measure the width of the Bollinger Bands. While Bollinger Bands allow you to identify periods of high and low volatility visually (tight bands indicate low volatility and wide bands indicate high volatility), Bandwidth provides the actual volatility value. The Bollinger Bandwidth formula is:
Bandwidth = (Bollinger Upper Band - Bollinger Lower Band) / Bollinger Middle Band
Volatility is high when the Bollinger Bandwidth moves to its high levels and volatility. It is low when Bandwidth moves closer to zero. As a rule, a stock's price and volatility moves in cycles - the price moves up and down and periods of low volatility are replaced by periods of high volatility. In general, periods of high volatility can be noted during down-trends and corrections downward. Periods of low volatility can be observed during up-trends and recoveries. With this knowledge a trader can build a trading system that generates signals based on the volatility technical analysis.
The Bollinger Bandwidth can be used to identify "the Squeeze" - when the Bandwidth is at its lowest low value within n-periods. Bollinger states that Squeeze could occur before a trend reversal, like "the calm before the storm". In this case, trading Buy/Sell signals can be generated on the price breakouts following the Squeeze.
As with all other volatility indicators, the Bollinger Bandwidth does not take into account price direction. Furthermore, this indicator does not signal the direction of the price. Therefore, it is recommended that you use volatility indicators (including Bollinger Bandwidth) in conjunction with other technical studies. Bollinger recommends using RSI and Accumulation/Distribution to confirm a Squeeze, but other price and volume based indicators could be used.
One of the most popular ways of using Bollinger Bandwidth and other volatility indicators is to look for a divergence between price and volatility. Based on the knowledge that lower volatility is typical of a bullish trend, an increase in volatility during an up-move may signal a coming reversal downward and can be used to generate a "Sell" signal. Conversely, technical analysis states that if the volatility starts to decline while the price is still moving down, it may indicate a coming reversal upward and can be used to generate a "Buy" Signal.
Besides generating signals, in technical analysis volatility is used to measure volatility with the purpose of adjusting other indicators accordingly, as well as defining stop-loss strategy (trailing stop-loss level).
Chart 1: S&P 500 index (^SPX) - Bollinger Bandwidth
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