Bollinger Bands help technical analysts determine breakout prices for a stock and more accurately define a trading range. They also help to identify volatility. The bands incorporate standard deviation to chart a top and bottom line on either side of a stock's moving average. There are several indicators created to work with Bollinger Bands to help make further inferences about trend reversals and price breakouts. Some of the most common indicators used by traders are BandWidth, %b and BBTrend.
Using the BandWidth Indicator
BandWidth, or BW, is the measure of the width of the bands relative to the middle band. One pattern traders look for with BW is called The Squeeze. It is identified as a narrow width caused by low volatility. Traders calculate a Squeeze using this formula: Top Band (20 periods) - Lower Band (20 periods) / Middle Band (20 periods). The Squeeze can also be easily seen on a chart and, as its name indicates, looks like the upper and lower bands are squeezing the middle band. Traders use this indicator as a signal that volatility is about to increase. They can combine this insight with signals from other indicators, such as the accumulation/distribution index, to identify the direction of the impending breakout. If price is currently heading down and indicators are heading up, the sign is bullish.
Using the %b Indicator
Another indicator used with Bollinger Bands is %b, which plots the stock's closing price as a percentage of the upper and lower bands. The upper band is identified as 1.0, the middle band 0.5 and the lower band zero. Thus, %b shows how close the stock's current price is to the bands. For example, if the upper band sits at $30 and the current price is $22.50, %b equals 0.75, putting the stock three-fourths of the way toward the upper band limit. This is helpful for traders to identify when a price jumps a band, which can determine divergences and trend changes.
Using the BBTrend Indicator
BBTrend is a relatively new indicator developed by John Bollinger to work with Bollinger Bands. It is one of only a few indicators that can signal both strength and direction, making it a very valuable tool for traders. BBTrend is calculated using the following code in the chart:
lower = abs(lowerBB(20) - lowerBB(50))
upper = abs(upperBB(20) - upperBB(50))
BBTrend = (lower - upper) / middleBB(20)
If the BBTrend reads above zero, the signal is a bullish trend, and if the BBTrend reading is below zero, the signal is a bearish trend. The degree above or below zero determines the strength or momentum behind the trend. The BBTrend indicator was still in beta testing in 2012, but it looks to be a great resource for technical analysts and offers an alternative to the average directional movement index, or ADX, which gives similar readings.