System Trading Made Easy With John Bollinger

Transcription

1 The Alternation Of Fear And Elation System Trading Made Easy With John Bollinger John Bollinger is an analyst, author, and president and founder of Bollinger Capital Management, an investment management company that provides technically driven money management services. Bollinger Capital Management also develops and provides proprietary research for institutions and individuals. He may be best known as the creator of Bollinger Bands, which he developed in the mid-1980s. Since then, investors and traders have come to view Bollinger Bands as a reliable tool for assessing expected price action, and the bands are featured on most financial charting software and websites. Bollinger s Capital Growth Letter, which has been published since 1987, provides market commentary, charts, and investment advice for the average investor employing a technically driven asset allocation approach. He has also developed several investor websites, among which are BollingerBands.com, EquityTrader.com, BollingerOnBollingerBands.com, BBScript.net, and a forex website, BBForex.com. John Bollinger, a longtime proponent of rational analysis, the combination of technical and fundamental analysis, was the first analyst to earn both Chartered Financial Analyst (CFA) and Chartered Market Technician (CMT) designations. S&C Editor Jayanthi Gopalakrishan and Staff Writer Bruce R. Faber interviewed John Bollinger via telephone on January 4, ohn, as you and your work are well known in our industry, can you begin by telling us the most recent things you ve been working on? A little more than two years ago, I had the pleasure of spending time with Ian Woodward, who has been doing some interesting things with Bollinger Bands. It was an inspiring time for me. Over the next few weeks, I realized that I could develop an entire framework of indicators around Bollinger Bands that covered virtually all of the traditional technical analysis tasks. J Where did you start? The first result was an indicator called BB Impulse, which quantifies price action in relation to the bands, and from there I went on to develop a trend indicator. I next developed a momentum indicator, and kept expanding the horizon until I had a complete suite of indicators that were all logically consistent and drawn from the same basic pool of technical information. I ve ended up with an array of new tools. I have been able to leave behind some older tools and replace them with better ones. It has been a great two years. The two projects I worked on went way back for me. When I created Bollinger Bands, I created two indicators to go with them, %b and BandWidth. %b tells us where we are in relation to the bands. If prices are at the upper band, %b is 1 and if prices are at the lower band, %b is zero. If prices are at the middle band, %b is 0.5. BandWidth tells you how wide the bands are. In order to measure that, we use the middle band, or the moving average, as a reference point. Those were the two building blocks we had to start with. And what was the second project? About that time I started thinking about a language in which we could express these ideas and exchange these ideas with other technicians and others who are interested in developing systems and The alternation of fear and elation dissuades people from investing. It pushes them away from the markets. approaches to the market. Using as a basis a logic we employed, I created a simple computer language and called it Trade. To get there we tried to overcome the disadvantages of traditional logic for traders. In traditional logic, everything is black or white, one or zero, yes or no, long or short. But that does not really model how traders think about the markets. So I worked with an engineer friend and developed a tristate logic, which was 1, 0, and 1. We could map that better onto the trading process that is, long, flat, or short. With that, we had a logic that modeled what traders did better. I wrote Trade to be able to communicate those ideas. All of these parts and pieces started to come together in the past couple of years. At some point I abandoned the tristate logic model because I realized that even that was not sufficient to describe what

2 traders really did. Traders often scale in or out of positions, or are 20% long, or 20% short, or some variation. So we combined the ideas of fuzzy logic from the original tristate model and produced a smooth-valued logic that describes how traders function in real life. Then the final piece was to write the language as a computer interface to express our ideas in a straightforward way. We wrote a compiler that would interpret those ideas and put them on the screen. It s been a very, very active two years, during which I pulled together a large number of threads from past years and combined them into a powerful framework for traders. Sounds like a lot of work. So how would a trader use something like that? It was an awful lot of ideas in a very short time, so it might be better to focus on a few of the indicators and how they might be used. Sure. Let s start with BB Impulse. BB Impulse was the first of the new indicators, and it measures price changes in relation to the bands. We find, for example, that in strong markets we tend to get a series of positive impulses. In weak markets you tend to get a series of negative ones. So by taking a look at the raw values of BB Impulse on the screen, your gaze is drawn to the essence of what is happening in the marketplace. If, on balance, the positive impulses are larger than the negative ones, you are in a rising market. If the negative impulses are larger than the positive ones, you are in a falling market. This is interesting because the shift from positive to negative can occur even while prices go sideways. It is like an X-ray at the interior of the momentum of the market. So we can extend those ideas with some decision rules. You could say, If in a rising environment, I get several strong negative impulses. I want to tighten my stops in this situation and play a more defensive strategy. Likewise, if we are in a falling market and we start to see a series of positive impulses coming into the market, then we can shift from a defensive strategy, or an outright short strategy, to neutral and then eventually to positive. Because these signals are derived from Bollinger Bands (BB), they adapt to market conditions. In a consolidation range, the strength or weakness necessary to create a big reading in BB Impulse is much smaller than it is in a trending market where the bands are spread apart. We have had basic momentum indicators for a long time, but by framing them with Bollinger Bands, they become adaptive to the type of environment. So in a consolidation range, prior to the movement, you can see the shift from a negative environment to a positive one. You would not be able to pick that up with a traditional momentum indicator. These have probably been active in the markets that we have seen lately. Correct, and in this prolonged trading range market that we have seen recently, these tools really shine. So the BB Impulse measures price changes. Have you measured anything else with some of the other indicators? What BB Impulse does is measure the daily change of %b. The formula for BB Impulse is: %b this period %b last period It incorporates the changing width of the bands and at the same time it captures price change. Price change is driving the changes in %b, so it is a fully adaptive framework to work with. The sister indicator to BB Impulse is BB Momentum. BB Momentum looks at the momentum of price in relation to the bands. It is the price change over a period, say of 10 periods, as a function of the bands. This is a momentum measure instead of being an instantaneous momentum measure like BB Impulse. Now it is kind of a classic momentum measure, like the 10-day rate of change that technicians might use, but it is adapted to the market. In a constricted range where the bands are tight, relatively small amounts of momentum will show up dramatically. When you get into a very volatile market, such as a very strong down period, it would take much greater regions of momentum to have an impact on this indicator. All of these indicators are scaling market activity via the lens of Bollinger Bands. A really interesting indicator is BB Trend. This is perhaps the most interesting for me because it helps determine what strategies we should be employing. BB Trend is a classic trend indicator much like average directional index (ADX), or other attempts that people have made to distinguish between trending and nontrending markets. Bollinger Bands of different periods align differently, depending on whether the market is trending. For example, if you take Bollinger Bands of 20 periods and 50 periods in an intermediate uptrend, you will see that the upper bands run almost together, aligning almost perfectly. You will see similar behavior in a strong downtrend with the lower bands. So I developed a formula that takes advantage of those relationships to tell us whether the market was trending. Again, it is an adaptive formula that is based on volatility and what is happening in the markets. It is very good at detecting trends early, just as they are forming. It has proved to be very useful because it tells us when to switch from trend-following strategies to congestion, or trading range strategies. Does the three pushes to a high a term that George Lane used frequently apply to BB Impulse and BB Trend? Oh, yes. Three pushes to a high is a great example, because you will see all of these indicators do different things. In three pushes to a high, BB Impulse will produce steadily lower groupings of positive readings as the three pushes occur. BB Trend will start to fade and turn down shortly after or coincident with the second push to the high, because the trend is starting to fail. The second push to the high is usually the last piece of the actual trend. It is the moment of trend failure. The third push to the high is kind of a retest. [See sidebar at end. Ed.] What you will find is that BB Trend will keep rising or stay at a high level during the first two phases of three pushes to a high, and as you get to the third phase,

3 BB Trend will have turned down. I should say that BB Trend also recognizes the direction of the trend, unlike the other tools that have been developed. It runs from +1 to 1. Strong readings above zero are indications of a positive trend, and strong readings below zero are indications of a negative trend. In addition, BB Momentum will be producing a series of lower highs as the three pushes occur. The highest reading will occur either on the first or second push. Usually, the rule is that the reading on the third push will be clearly lower than the readings on either the first or second. What George Lane did, which I think is pretty fantastic, is that he viewed everything through the lens of stochastics. He recognized this very typical, psychological progression as a strong burst of momentum followed by another strong burst, followed by a weaker burst. There was a psychological pattern related to those pieces and he interpreted that pattern using stochastics. I went back and studied stochastics carefully. I was fortunate to have met George Lane and I actually traveled with him, and I learned from him. I took the modern version of stochastics, starting with %K and did a threeperiod smoothing to arrive at %D, and then did another smoothing to arrive at slow stochastics. Since I used the formula for stochastics to calculate %b, I also took those two smoothings and added them to %b and came up with %b in the classic stochastic manner. I found that to be a great help. It s really made it easier to clarify the patterns on the chart. It is hard to deny what s happening when all three lines have either turned down or turned up. Does the interface you created combine all these indicators? It does. What I wanted Trade which we now call BB Script to be is a simple language that traders could use to realize their ideas without having to learn a programming language. So we took Trade and converted it into a fullon trader s language called BB Script, and built an interpreter for it right into our EquityTrader.com charting package. So you can just slip out of your chart by clicking a tab, look at your script, make a small change in it to fine-tune your system, then click right back in. That change is immediately reflected in the chart. That sort of power has been available for a long time in PC-based software, but you had to know programming. So we did two things: we made it simple and we took it away from the programming world. It is a very English-like language. It is very easy to write, very straightforward, and we made it web-based so you don t have to have software running on your PC. It is a cloud-based technical language that is also completely secure. What kind of challenges did you confront developing these indicators? As I ve mentioned, it has been an incredible couple of years. I ve learned as much in these last two as I learned in the previous 10. It just took a little push for me to realize that there was this analytical framework that I could create. Once I started working on it, the pieces just fell into place. One of the first ideas I had was what I called BB Delta, which I abandoned and replaced with BB Momentum. BB Delta was the one-day rate of change of price divided by Bollinger Bands. I looked at it and decided it was an interesting tool, but it duplicated the information in BB Impulse. About three months later I realized the thing to do, instead of looking at the one-day rate of change, was to let the user pick the rate of change. It could be a five-day rate of change, or 10 days, or 20. That way, we were looking at the classic measure of momentum in relation to Bollinger Bands in the same way we were looking at price changes in relation to BB. Making that simple little change created what turned out to be a new and powerful tool. But I didn t see that at first. I was just going to discard the concept. Yet lying right there was a great tool. I just had to visualize what the change was that would make it that tool. Sounds like you are also very passionate about your work. I am more passionate about my work now than I have been in a long time. These two years have been inspiring, because they have opened up new doors. If anything, I am more interested in this work than I was five years ago. There are a lot of people out there who don t want to learn a computer language or write code. Yes, and that is why BB Script is so nice. You don t have to be a programmer. You can sketch these ideas out in an English language like interface, and then see them as an indicator right there on the chart. Did George Lane have any input into your new Bollinger Band indicators? In the CompuTrac days, Tim Slater would get together a panel of three to five technical experts and we would travel to various countries. I went on a trip with George Lane and Manning Stoller, and others. We made presentations in Singapore, and Hong Kong, and Tokyo. Watching George Lane teach was inspirational. He was a fantastic teacher. He had real passion for his work. His father was a Bible Belt revival-tent preacher and George had that in him. When he got excited he would turn up the volume and you could see his passion for the subject. I loved listening to him. I named %b for the same naming procedure used for stochastics, %K, and %D, as a homage to George. I wanted to make sure these people who had been pioneers in this field got full credit for their work as I used it for my own purposes. Did Ian Woodward have any input into the development of your new Bollinger Band indicators? Ian Woodward is an amazing guy. Like Arthur Merrill, he had a long career in industry Ian as an engineer at Xerox, Arthur as a statistician at GE. They both took up technical analysis upon retirement and made second careers in it. A couple of years back, a mutual friend arranged for Ian to drop by and show me the work he was doing, and I was very impressed. Here was a man nearly 80 years old with more ideas and energy than most people half his age. He has taken input

4 from William O Neil, Richard Arms, and me and crafted an approach to investing that seeks to identify and participate in high-growth stocks. He gives three-day seminars twice a year that are jam-packed with interesting ideas. I even had one of the guys who works for me attend. I think that in the fullness of time he ll be known as one of the great analysts. There was about a week back in early August 2011 when the market was up 300, down 300, up 500, and down 400. It was basically a sideways market, but it was so volatile that I have to wonder how that affected your new indicators. It was the most volatile period in terms of short-term volatility that I can recall. I actually went back over past years charts trying to see if I could spot a period where the short-term volatility had been that high. There were a few days in the debacle where we got some very big one-day reversals, went down huge then reversed and ended up on the day. But I could not find another example of this sort of alternating of big up days and big down days. I thought maybe the bottom in 1998 would be characterized by similar action. If you remember, we came down sharply, then bounced for a very short time, then came right back down and retested the lows, then turned on a dime and went north. But even that, which we felt was a very volatile period, was nothing like what we experienced last year. In terms of what it does to our new Bollinger Band indicators, they reflect that action fully. BB Momentum or BB Impulse reflect the big price moves that you get, but nothing breaks because things are scaled by volatility. When volatility is very high, then the scaling is wide. It tends to put that activity into perspective rather than magnify it. Did the indicators give you any indication while it was happening as to which way it was going to go? If there were a system or an approach that would have done so, I have no idea what it would be. My tools worked pretty well through the period and they allowed us to recognize the bottom when it arrived. But during that period where we were getting whipped back and forth, I don t think anything worked, whether it was fundamental, technical, or quantitative. Even pair traders were blown up in that period because the normal relationships between the pairs they traded were destroyed in that volatility. That was about as hostile a circumstance that the market is capable of producing as I have ever seen. It was one of those times when one day you d think you could retire now and the next day you think you d have to keep working for many more years. That s pretty typical of how people reacted. The alternation of fear and elation, I think, dissuades people from investing. It pushes them away from the markets, not because they made money or lost money, but simply because the environment itself was so hostile that they have trouble trying to figure out why in the world they should be involved at all. It was a pleasure talking to you, John. Suggested reading Bollinger, John [2001]. Bollinger On Bollinger Bands, McGraw-Hill. Gopalakrishnan, Jayanthi [2002]. John Bollinger Of Bollinger Bands Fame, Technical Analysis of Stocks & Commodities, Volume 20: May. Hartle, Thom [1997]. John Bollinger And Group Analysis, Technical Analysis of Stocks & Commodities, Volume 15: April.

5 THREE PUSHES TO A HIGH PATTERN These three charts illustrate a classic technical pattern called three pushes to a high delineated by Bollinger Bands and the BB indicators %b, BandWidth, and BBTrend. This is a term that was popularized by the late George Lane, generally referred to as the father of stochastics. The three pushes to a high often signifies the end of a long top formation. Each push has a specific reference: First Push You will see the market make a new high (its first push), with prices often pushing themselves outside of the upper Bollinger Band. This is followed by a retracement that could take prices to the middle Bollinger Band. Second Push Prices make a new high at about the upper Bollinger Band. This is followed by a retracement, not necessarily to the middle Bollinger Band. Third Push The final push is when price makes that last attempt to hit a high but starts to lose momentum. SIDEBAR FIGURE 1: The SPDR Gold Trust ETF, GLD with Bollinger Bands and %b. Here is an example of the three pushes to a high pattern with three lower peaks in %b. In three pushes to a high, BB Impulse will produce steadily lower groupings of positive readings as the three pushes occur. BB Trend will start to fade and turn down shortly after or coincident with the second push to the high. The second push to the high is usually the last piece of the actual trend. It is the moment of trend failure. The third push to the high is a retest. What you will find is that BB Trend will keep rising or stay at a high level during the first two phases of three pushes to a high, and as you get to the third phase, BB Trend will have turned down. BB Trend also recognizes the direction of the trend. Strong readings above zero are indications of a positive trend, and strong readings below zero are indications of a negative trend. BB Momentum will be producing a series of lower highs as the three pushes occur. The highest reading will occur either on the first or second push. Usually, the rule is that the reading on the third push will be clearly lower than the readings on either the first or second. Lane viewed everything through the lens of stochastics. He recognized this psychological progression as a strong burst of momentum followed by another strong burst, followed by a weaker one. There was a psychological pattern related to those pieces and he interpreted that pattern using stochastics. SIDEBAR FIGURE 2: The SPDR Gold Trust ETF, GLD with Bollinger Bands and BandWidth. Here is an example of the three pushes to a high pattern with BandWidth turning down on the second push. SIDEBAR FIGURE 3: The SPDR Gold Trust ETF, GLD with Bollinger Bands and BBTrend. Here is an example of the three pushes to a high pattern with BBTrend turning down on the third push.

6 BOLLINGER BAND SUITE The following tools make up the Bollinger Band suite of technical analysis tools. Bands and envelopes: n Bollinger Bands (for markets where the trading session is well defined) n Bollinger Envelopes (for markets where the session definition is poor) Are prices high or low? This group of BB indicators focus on price action: n %b (This was the first BB indicator.) Where are we in relation to the Bollinger Bands? n BBImpluse Instantaneous price action in relation to the Bollinger Bands. n BBMomentum (A single-period version of this called BBDelta was the first of the new indicators.) What is momentum in relation to the Bollinger Bands? This group of BB indicators focus on volatility: n BandWidth (This was the second BB indicator.) How wide are the Bollinger Bands? n BandWidth Delta Are the Bollinger Bands expanding or contracting? n %BandWidth Where is BandWidth in relation to history? This BB indicator focuses on trend: n BBTrend Are prices trending and, if so, in what direction? BBScript This BBScript plots the BBmomentum indicator. John Bollinger // Copyright John Bollinger, CFA, CMT 2012 // // use the data from the chart data("x") // use the close myclose = close(x) // middle BB middlebb = sma(myclose, 20) // volatility vol = stdev(myclose, 20) // upperbb upperbb = middlebb + 2 * vol // lower BB lowerbb = middlebb - 2 * vol // momentum mtm = myclose - myclose[-10] // BB momentum BBmtm = mtm / (upperbb - lowerbb) // create the plot objects myplot = plot(bbmtm, "BBmtm", "histogram","cc0000") // draw the charts using the plot objects chart(myplot) John Bollinger