Now that you have the standard deviation-volatility idea down, you can roll right on to Bollinger bands for a practical way to put what you know to work.

When I first looked at charts with Bollinger bands, it seemed as though they were drawn on top of prices. How they predicted anything was not at all obvious.

But the Bollinger band is a variation of standard deviation. Instead of being calculated from closing prices, it’s based on a 20-day moving average. The normal setting is 20 day-average.

Everything else we said above still applies. Most price movement occurs within one or two standard deviations. And the Bollinger bands simply show where the line is. Look at Proctor and Gamble:

In this chart, the middle dotted line is the moving average. The outside blue lines are the two Bollinger bands. One is one standard deviation above the moving average, the other is one standard deviation below it.

The box at the bottom of the chart is Bollinger band with, which is equal to two standard deviations. This is how much you can reasonably expect a stock to move in a short term. If the stock is trending, it will tend to “walk a band,” as PG does in August and September. Even with this strong momentum going for it, though, you will note that the price tends to stay within the bands.

In January 2008, you see the price drop suddenly outside the lower band. And then it snaps right back into range. This, too, is typical. A big move outside a band is almost always a surprise that is related to news, especially after quarterly reports. This followed earnings that barely beat expectations.

Other than staying within Bollinger bands, the predictive part has to do with band width. Volatility is relative to something, no matter how it’s measured. And it changes over time. Only things like bonds that pay 5% interest every quarter have zero volatility. Everything else moves more sometimes than other times. So volatility expands and contracts. That’s something I like to look for. Extremely low volatility often precedes a breakout. In other words, when your stock has gotten too dull, you had better brace yourself!

A better picture of a volatility squeeze:

Sprint was getting predictable—ugly, but predictable. It consistently headed down. Volatility reached an extreme low in April, then… fireworks! The stock not only made a big move, it turned around.

Much more often, you will see a stock break out of a range and go up or down in a large bound after a squeeze like this. The pattern in Sprint was dramatic, but a little more unusual in making a complete turnaround. Nonetheless, whenever volatility reaches a low of six months or longer, chances are good that something big will happen soon.

What’s the chart saying today? Even though the stock is falling, it probably isn’t headed below $8.90. And if it should jump, just under $10 is the likely max for the time being.

That’s the end of our volatility series. Now, instead of viewing it as the enemy with unknown madness, you can make friends and put it to work for you.

Source: The Well-Behaved Stock