A moving average envelope creates a channel that parallels another moving average. This allows you to identify the trend and use the upper and lower boundaries as Support and Resistance Levels. Bollinger Bands are a modification of such moving average envelopes. Rather than surrounding the moving average by a constant percentage, Bollinger Bands use a measure of historical volatility to adjust their bandwidth. Figure 36A includes moving averages and different other upper and lower statistics that can be used in congestion with Bollinger Bands.
Figure 36B, includes an example of Bollinger Bands. Bollinger Bands can be used for stocks and indexes, especially during market sell off. It can be used to measure market volatility, trend, and whether the market is oversold or overbought. The red colored lower band in the example is considered to be an oversold condition.
Bollinger Bands are similar to moving average envelopes with one key distinction – they reflect Volatility. We can construct Bollinger Bands by applying a simple moving average, usually of 50 days, to a stock and then applying an envelope to the moving average. This means that the range between the two Bollinger Bands at any given time represents 95% of the price movement or trading range for the past 50 days. Keep in mind that Bollinger Bands are a reflection of past performance of underlying assets. Each strategy using Bollinger Bands relies on the indicator’s excellent ability to identify volatility levels.
The squeeze takes advantage of the sudden increase in Volatility that generally occur after periods of containment. When a stock trends in a flat range, the bands constrict and eventually become very narrow. In most cases, when a stock price has been constrained for a prolonged time period, it eventually exploded out of its trading range. This increased volatility causes the Bollinger Bands to widen dramatically.
Figure 36C, the daily Chart of Groupon depicts an example of Squeeze. You can identify potential Squeeze Trades when Bollinger Bands constrict to their narrowest position over the past four to six months.
In Figure 36D, the Buy Signal $SPX broke above its moving average at $1950. The Index exceeded the upper band and moved above it for the month. On the other hand, Sell Signal happened when the Index price crossed below the 50 days moving average or when the upper band began to trend back down towards the moving average.