Bollinger Bands: Buy Low and Sell High?

Posted in Technical Trading July 5, 2007 Share Post Are Bollinger Bands valuable tools for discovering overbought/oversold conditions in the aggregate stock market? Can traders build trading strategies around them? To check, we analyze the historical behavior of three sets of Bollinger Bands around the 21-trading day (one month) simple moving average of the S&P 500 index. The three sets of bands correspond to 1.5, 2 and 2.5 standard deviations for the moving windows of analysis. When the daily price crosses above (below) the upper (lower) Bollinger Band, we designate that day a SELL (BUY) at the close, holding the position for the next 21 trading days. Using S&P 500 index daily closing levels for January 1950 through June 2007 (about 688 independent 21-trading day windows), we find that The following table summarizes results for all three sets of Bollinger Bands. For example, there are 702 BUY signals and 801 SELL signals using Bollinger Bands of 2 standard deviations. The average 21-trading day return after BUY (SELL) signals is 1.03% (0.66%), and the standard deviation of these returns is 5.15% (3.54%). The average return for all 21-trading day intervals in the entire sample is 0.74% with standard deviation 4.15%. In general, average returns after BUY signals are both higher than those after SELL signals and above the average for the entire sample, However, the average return after SELL signals for the 2.5 standard deviation bands are about the same as that after the BUY signals and above the average for the entire sample. Returns are consistently more volatile after BUY signals than SELL signals.

These signals are not tradable because many occur in bunches. A trader committing all-in to the first signal in a bunch would have no capital available to play the subsequent signals in that bunch. To measure tradable statistics for the BUY and SELL signals, we thin the sample such that no two BUY and no two SELL signals fall within 21 trading days of each other. The second table summarizes the statistics for the thinned sample, with greatly reduced numbers of BUY and SELL signals. The most notable change in returns is the drop in the average return after BUY signals for the 2.5 standard deviation Bollinger Bands. This thinned subsample is unlucky in that it contains the October 1987 plunge and three other large drops. For the 1.5 and 2 standard deviation bands, results are fairly consistent with those above.

As a simplified measure of the economic value of S&P 500 index Bollinger Bands, we use the raw data for the second table to construct a trading strategy (assuming there is a vehicle to trade the index) that exploits the abnormal average returns after the BUY signals for the 1.5 and 2 standard deviation bands. We then compare the outcomes of this strategy with that of buy-andhold. The trading strategy consists of buying at the close after each BUY signal and selling at the close 21 trading days later, thus generating 301 (234) round-trip trades for the 1.5 (2) standard deviation bands. Ignoring trading costs, return on cash when out of the market and tax effects, we find that: The strategy as applied to the 1.5 standard deviation Bollinger Bands generates a 1105% return over 57.5 years. This strategy is out of the market about 56% of the time. It may have produced substantial net interest income while out of the market, but also mostly short-term capital gains (it involves an average five round-trip trades per year). The strategy as applied to the 2 standard deviation Bollinger Bands generates a 757% return over 57.5 years. This strategy is out of the market about 66% of the time. It also may have produced substantial interest income while out of the market, but again mostly short-term capital gains (an average four round-trip trades per year). Buy-and-hold generates a return of 9053% over 57.5 years, winning easily because the stock market still goes up on average during the months the Bollinger Band strategy is out of the market (and compounding of such returns is powerful). In summary, Bollinger Bands for the aggregate stock market do provide some sense of overbought/oversold (and future volatilty), but they do not as standalone indicators support a trading strategy that beats buy-and-hold.