Page 224 - THE MARKET WHISPERER

220 PART 7 - Indicators: The Trader’s Compass

distance on the basis of a fixed percentage, but on a known statistical
method which you might well have learned years ago, called “standard
deviation.” Standard deviation is a calculated statistical value representing
the volatility of data. Using the standard deviation, we can measure stock
volatility, and thus use deviation to set the distance between the bands
and the MA in a way that adapts to stock volatility. The beauty of the
standard deviation is the fact that the distance between the bands expands
when stock volatility increases, and lessens when stock volatility drops.
In actuality, Bollinger created a tube that shrinks or expands according
to volatility, and thereby significantly and successfully increased the
method’s reliability. An exhausting explanation. This is likely the stage
when you wish to know its application.

If we commence with the premise that in the vast majority of cases, a
stock will move between the bands, then when the price reaches the upper
line, this means the stock is in a state of “overbought” and therefore
should return downward. By contrast, when the stock price drops to the
bottom line, it means that the stock is in a state of “oversold,” and there is
a reasonable probability that it will now return upwards.

When you define Bollinger bands on your charts, you will need to take
into account the following data: the MA should be set to ten periods and the
SD (standard deviation) should be set at 1.5. In other words, the Bollinger
bands wrapped around the movement of the stock you are watching will
be calculated according to volatility over the past ten trading days. The
mathematical value of the SD is that 90% of the stock’s movements will be
captured between the two bands.

When I take into account in advance that the Bollinger bands according
to the parameters above will encompass 90% of the stock’s movement,
should the premise not be that a stock which has gone beyond these
boundaries would not return inside them? Can this mathematical fact not
define a trading method with more than 90% success rate? Yes, of course
it can. We will learn more about this in the chapter on trading methods.