Bollinger Bandwidth is one of the few technical indicators that measures volatility.
This technical indicator measures the distance between the upper and lower Bollinger Bands. The Bands contract and expand with volatility. Bollinger Bandwidth quantifies the volatility and can be added to the chart to help spot when big price moves are likely to occur. Volatility tends to move in a cyclical pattern, and big price moves often follow periods of low volatility.
Bollinger Bandwidth is calculated by taking the difference between the upper Band and the lower Band and dividing that difference by the moving average of the closing prices (i.e., the middle Band). The indicator will always be between 0 and 100, with low values corresponding to low volatility and high values corresponding to high volatility. It can be used in any time frame.
How Traders Use It
Bollinger Bands and Bandwidth were developed by market analyst John Bollinger. He details a strategy that he calls "The Squeeze" as a trading setup that uses Bandwidth.
Bollinger Bands expand and contract with the price action. Increased volatility drives an expansion in the Bands and lower volatility squeezes the Bands together. As a measure of the distance between the Bands, Bandwidth shows these changes in volatility as a single, easy-to-use indicator. Low volatility is often followed by high volatility, and a squeeze is a signal that a volatile period is likely to begin soon, meaning a price breakout is likely to occur.
Using Bandwidth, a squeeze is represented by a low value of the indicator. Some traders like to see a 125-day low in the value of the Bollinger Bandwidth as an indicator that a squeeze is set up. Other indicators are then used to confirm the direction of the expected price breakout.
A squeeze only indicates that a big move is likely to occur; it does not forecast direction. This is shown in the example below. One squeeze signaled a price decline and the next one came before a price gain. Momentum indicators, like Moving Average Convergence/Divergence (MACD), can be useful in forecasting the direction of the breakout.
MACD has been added in the next chart. It is falling as the first squeeze is signaled and rising when the second one occurs. Traders could use other momentum or trend following indicators to determine how to trade the squeeze.
Why It Matters To Traders
Traders have very few tools to evaluate volatility on individual securities. Bollinger Bandwidth is one of them, and it offers clear and frequently timely signals.
Traders can make the most profits in the most volatile positions. Watching for a squeeze setup will help the trader get into potentially volatile trades early.
(This article originally appeared on ProfitableTrading.com.)