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Trading bands, which are lines plotted in and around the price structure to form an envelope, are the action of prices near the edges of the envelope that we are interested in. It's not the newest of ideas, but as John Bollinger of Bollinger Capital Management points out, it's one of the most powerful concepts available to the technically based investor, answering not whether absolute buy and sell signals are being given but whether prices are high or low on a relative basis. Trading bands can forewarn whether to buy or sell by using indicators to confirm price action. How do trading bands work? Bollinger, of Bollinger Bands fame, explains how.

Trading bands are one of the most powerful concepts available to the technically based investor, but they do not, as is commonly believed, give absolute buy and sell signals based on price touching the bands. What they do is answer the perennial question of whether prices are high or low on a relative basis. Armed with this information, an intelligent investor can make buy and sell decisions by using indicators to confirm price action.

But before we begin, we need a definition of what we are dealing with. Trading bands are lines plotted in and around the price structure to form an ''envelope". It is the action of prices near the edges of the envelope that we are particularly interested in. The earliest reference to trading bands I have come across in technical literature is in The Profit Magic of Stock Transaction Timing; author J.M. Hurst's approach involved the drawing of smoothed envelopes around price to aid in cycle identification. Figure 1 shows an example of this technique Note in particular the use of different envelopes for cycles of differing lengths.

FIGURE 1: The trading bands or envelopes are first drawn by hand over the price series. An average width is determined by measuring the distance from the top and bottom of the bands.

Asking the market what is happening is always a better approach than telling the market what to do.

The next major development in the idea of trading bands came in the mid- to late 1970s, as the concept of shifting a moving average up and down by a certain number of points or a fixed percentage to obtain an envelope around price gained popularity, an approach that is still employed by many. A good example appears in Figure 2, where an envelope has been constructed around the Dow Jones Industrial Average (DJIA). The average used is a 21-day simple moving average. The bands are shifted up and down by 4%. The procedure to create such a chart is straightforward. First, calculate and plot the desired average. Then calculate the upper band by multiplying the average by 1 plus the chosen percent (1 + 0.04 = 1.04). Next, calculate the lower band by multiplying the average by the difference between 1 and the chosen percent (1- 0.04 = 0.96). Finally, plot the two bands. For the DJIA, the two most popular averages are the 20- and 21-day averages and the most popular percentages are in the 3.5 to 4.0 range.