Lee Bohl: Sure. I think to understand what that means let's just review very quickly what the Bollinger band indicator is seeking to tell us. It is trying to give us an idea of volatility. And the way it does that is it has a measure of central tendency which is a moving average of prices. And then the bands are set above and below that measure of central tendencies based on a volatility measure which is the standard deviation of price. So if things are volatile of course the spread of prices which makes up the standard deviation calculation are wider, the bands are further apart. If things are not as volatile then of course the standard deviation of price is less and they collapse down. In an extreme case they can collapse down a lot. All right. Now I'm a technical analyst. We don't agree much often with fundamental analysts but one thing we do both agree on is that volatility is needed. So what that means is generally speaking periods of high volatility are followed by periods of low volatility and vice versa.
So if you see where the Bollinger bands are really close together it's saying that you are in a low volatility situation. Now the question is of course well, how do I know what that is? Well Mr. Bollinger himself in his book said that look at a chart about six months long. If the bands are as narrow as they've been during that time frame you are actually in a squeeze. So what does that tell you? Think about it like this. You're putting a spring into a jack in the box. Eventually it's going to break. Right? When volatility reverts to the mean. You don't know which direction but you do know that you're setting up for a decisive move.
Lou Mercer: Let's pull up Lee's chart once again on the screen there. Lee, I was overhearing you talking to a client and it was really eye opening to that client where they were talking about some ways to use Bollinger bands that weren't necessarily the right ways to use them. Are there some common mistakes that clients make when trading Bollinger bands?
Lee Bohl: Yes. So the first thing – and I'm going for Mr. Bollinger again. They're his bands. Ok. So what Mr. Bollinger said is there is absolutely nothing of a touch of a band which is in of itself a signal to do anything. Now it could be. All right. So a lot of people they will say, ok, for instance if you can see this in here. We have gone down to the lower Bollinger band. It's a buy. No, it's not. Ok. Yes, it can be a buy when you hit the lower part of the band if the bands are relatively horizontal. All right? But notice how they started turning down due to the volatility. So that actually occurs a lot. That is called walking the band. Ok. So here is – that's one mistake that people use just a hint of a band is a signal to do something.
Lou Mercer: And then at the beginning of March we see the same thing. Right? The stock comes out of the bottom band.
Lee Bohl: Right. Right. Now a good way to use Bollinger bands and the way Mr. Bollinger thought was a good idea is you can use them to help you pick tops and bottoms. The way you do that is first you have to decide what are Bollinger bands really telling us. They're really telling us what our relative highs and relative lows and let me explain that to you. Let's say a stock runs up and makes a high. Ok. It pulls back. Now the volatility starts picking up. The stock goes up a little higher marginally. Is that really a higher high if you consider the effects of volatility? That's what Bollinger bands are trying to tell us.
Ok. So using that they can help us clarify tops and bottoms. Here is a perfect example actually in March in Intel. All right. Notice how we went down and made a low. Clearly outside of the lower Bollinger band, right? Notice the rally and then notice the second low. It is lower than the first one, isn't it? But you notice something else that's inside the lower Bollinger band? So that's telling us actually on a relative basis it is a higher low. You wouldn't normally think about buying a lower low 'cause it looks like the trend is continuing lower. But this is telling you that it is not a lower low on a relative basis and you can see that wasn't a bad time.
Kevin Horner: So that actually signaled strength at least in the short run off of that move.
Lee Bohl: That's correct.
Kevin Horner: Even though it was inside the band instead of outside the band.
Lee Bohl: That's correct.
Kevin Horner: Interesting.
Lee Bohl: And of course the opposite side of that trade would be a double top where you make the first high outside of the band. You pull back off into the moving average. We sometimes call that the middle band. And then you rally up again. You could even make a higher high but if it's inside the upper band it gives you more confidence that that is a top.