You'd be hard-pressed to find a trader who has never heard of John Bollinger and his namesake bands. Most charting programs include Bollinger Bands®. Although these bands are some of the most useful technical indicators if applied properly, they are also among the least understood. One good way to get a handle on how the bands function is to read the book "Bollinger on Bollinger Bands®," in which the man himself explains the whys and hows.
According to Bollinger, there's one pattern that raises more questions than any other aspect of Bollinger Bands®. He calls it "the Squeeze." As he puts it, his bands "are driven by volatility, and the Squeeze is a pure reflection of that volatility."
Here we look at the Squeeze and how it can help you identify breakouts. (See also: "The Basics of Bollinger Bands®.")
The Basics of Bollinger Bands
A Bollinger Band®, as we mentioned above, is a tool used in technical analysis. It is defined by a series of lines that are plotted two standard deviations—both positively and negatively—away from the simple moving average (SMA) of the price of a security.
Bollinger Bands® identify a stock's high and low volatility points. While it can be a real challenge to forecast future prices and price cycles, volatility changes and cycles are relatively easy to identify. This is because equities alternate between periods of low volatility and high volatility–much like the calm before the storm and the inevitable activity afterward.
Here is the Squeeze equation:
BBW = Bollinger Band® width
TBP = top Bollinger Band® (the top 20 periods)
BBP = bottom Bollinger Band® (the bottom 20 periods)
SMAC = simple moving average close (the middle 20 periods)
A Squeeze candidate is identified when the bandwidth is at a six-month low value.
When Bollinger Bands® are far apart, volatility is high. When they are close together, it is low. A Squeeze is triggered when volatility reaches a six-month low and is identified when Bollinger Bands® reach a six-month minimum distance apart.
Determining Breakout Direction
The next step—deciding which way stocks will go once they break out—is somewhat more challenging. To determine breakout direction, Bollinger suggests that it is necessary to look to other indicators. He suggests using the relative strength index (RSI) along with one or two volume-based indicators such as the intraday intensity index (developed by David Bostian) or the accumulation/distribution index (developed by Larry William).
If there is a positive divergence—that is, if indicators are heading upward while price is heading down or neutral—it is a bullish sign. For further confirmation, look for volume to build on up days. On the other hand, if price is moving higher but the indicators are showing negative divergence, look for a downside breakout—especially if there have been increasing volume spikes on down days. (For more, see: "Using Bollinger Bands® to Gauge Trends.")
Another indication of breakout direction is the way the bands move on expansion. When a powerful trend is born, the resulting explosive volatility increase is often so great that the lower band will turn downward in an upside break, or the upper band will turn higher in a downside breakout.
See Figure 1 below, showing a Squeeze pattern setting up in the year leading up to a KB Home (KBH) breakout. Bandwidth reaches a minimum distance apart in May (indicated by the blue arrow in window 2), followed by an explosive breakout to the upside. Note the increasing relative strength index (shown in window 1), along with increasing intraday intensity (the red histogram in window 2) and the accumulation/distribution index (the green line in window 2), both of which (demonstrated by line A) are showing positive divergence with price (demonstrated by line B). Note that the volume build that occurred beginning in mid-April through July.
Figure 1 – Courtesy of Metastock.com
The Head Fake
A third condition to look out for is something Bollinger calls a "head fake." It is not unusual for a security to turn in one direction immediately after the Squeeze, as if to trick traders into thinking the breakout will occur in that direction, only to reverse course and make the true and more significant move in the opposite direction. Traders who act quickly on the breakout get caught offside, which can prove extremely costly if they do not use stop-losses. Those expecting the head fake can quickly cover their original position and enter a trade in the direction of the reversal.
In Figure 2, Amazon appeared to be giving a Squeeze set-up in early February. Bollinger Bands® were at a minimum distance apart, which had not been seen for at least a year, and there is a six-month low bandwidth (see line A in window II). There is negative divergence between the RSI (line 1 of window I), the intraday intensity (line 2 of window II), accumulation/distribution index (line 3 or window II), and price (line 4 of window III)—all of which point to a downward breakout.
Breaking above the 50-day moving average (the orange line in the lower volume window) on drops in stock price, suggesting a build up in selling pressure, volume shows above normal values on downside price moves. Finally, the long-term trend line is breached to the downside in the first week of February. A downside breakout would be confirmed by a penetration in the long-term support line (line 5 of window III) and a continued increase in volume on downside moves.
Figure 2 – Courtesy of Metastock.com
The challenge lies in the fact that the stock had demonstrated a strong uptrend, and one pillar of technical analysis is that the dominant trend will continue until an equal or greater force operates in the opposite direction. This means the stock could very well make a head fake down through the trendline, then immediately reverse and break out to the upside. It could also fake out to the upside and break down. While it looks set to break out to the downside along with a trend reversal, one must await confirmation that a trend reversal has taken place and, in case there is a fake out, be ready to change trade direction at a moment's notice.
To Squeeze or Not to Squeeze?
Just like any other strategy, the Bollinger Squeeze shouldn't be the be-all and end-all of your trading career. Remember, like everything else in the investment world, it does have its limitations. If you follow it too closely and don't consider the risks—and limit them—you could stand to lose. Do your research, take care of your capital, and know when you should make an exit point, if necessary.
The Bottom Line
The Squeeze relies on the premise that stocks constantly experience periods of high volatility, followed by low volatility. Equities that are at six-month low levels of volatility, as demonstrated by the narrow distance between Bollinger Bands®, generally demonstrate explosive breakouts. By using non-collinear indicators, an investor or trader can determine in which direction the stock is most likely to move in the ensuing breakout. With a little practice using your favorite charting program, you should find the Squeeze a welcome addition to your bag of trading tricks. (For additional reading, check out: "Tales From the Trenches: A Simple Bollinger Band® Strategy.")