15 BASIC RULES

In closing, here are 15 basic rules to remember regarding Bollinger Bands:

1. Bollinger Bands provide a relative definition of high and low.

2. That relative definition can be used to compare price action and indicator action to arrive at rigorous buy and sell decisions.

3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, intermarket data, etc.

4. Volatility and trend already have been deployed in the construction of Bollinger Bands, so their use for confirmation of price action is not recommended.

5. The indicators used for confirmation should not be directly related to one another. Two indicators from the same category do not increase confirmation. Avoid collinearity.

Part VI: Summing Up

6. Bollinger Bands can be used to clarify pure price patterns such as M-type tops and W-type bottoms, momentum shifts, etc.

7. Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.

8. Closes outside the Bollinger Bands can be continuation signals, not reversal signals-as is demonstrated by the use of Bollinger Bands in some very successful volatility-breakout systems.

9. The default parameter of 20 periods for calculating the moving average and standard deviation and the default parameter of 2 standard deviations for the BandWidth are just that, defaults. The actual parameters needed for any given market or task may be different.

10. The average deployed should not be the best one for crossover signals. Rather, it should be descriptive of the intermediate-term trend.

11. If the average is lengthened, the number of standard deviations needs to be increased simultaneously-from 2 at 20 periods to 2.1 at 50 periods. Likewise, if the average is shortened, the number of standard deviations should be reduced-from 2 at 20 periods to 1.9 at 10 periods.

12. Bollinger Bands are based upon a simple moving average. This is because a simple moving average is used in the standard deviation calculation and we wish to be logically consistent.

13. Be careful about making statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The sample size in most deployments of Bollinger Bands is too small for statistical significance, and the distributions involved are rarely normal.

14. Indicators can be normalized with %b, eliminating fixed thresholds in the process.

15. Finally, tags of the bands are just that-tags, not signals. A tag of the upper Bollinger Band is not in and of itself a sell signal. A tag of the lower Bollinger Band is not in and of itself a buy signal.

WRAPPING IT UP

This book opened with a discussion of relativity, so it is only fitting that we return to relativity in the end. Oliver Wendell Holmes, Jr., believed that jurisprudence must adapt to the times, and he fought against judges bringing their own beliefs to bear on their cases. In this regard Holmes can be seen as a prototype for the enlightened investor. He weighed matters in a context that was relative to the case, to the law, and to society. He did not let his emotions carry him along, nor did he let his personal beliefs blur his decisions. In addition, he was dead set against judges making the law. These principles-relativity, discipline, and judicial restraint-are directly applicable to investing. To be a Holmeslike investor, test your beliefs to see whether they are true, make your decisions in a relative framework, do so without letting your emotions color the process, and do not change the rules as you go.