If you don’t know about Bollinger bands, you should. This technical indicator, which helps identify high-percentage trades from the myriad opportunities that present themselves each day, is one of the best indicators traders have in their toolkit. You can use Bollinger bands in countless ways to help refine the process of finding entry and exit points, but here are a few key points to help you get started.
The Basics of Bollinger Bands
While the math that underpins Bollinger bands is complicated, the concept is simple. Bollinger bands measure a stock’s volatility in relation to a “central tendency,” usually its 20-day moving average. For any stock or index, there will be a middle band, which measures the central tendency, and upper and lower bands, which measure a certain amount of standard deviations from the central line.
Most chart displays show two standard deviations, which implies that about 95% of the time, the stock should trade within this range.
Click to EnlargeThe dotted line is the central tendency, and the two solid lines are the upper and lower bands. Note how for the vast majority of the six-month period, shares of Newmont Mining (NYSE:NEM) stayed within the upper and lower bands. Note also that when the stock moved outside of these bands, it tended to revert to the central tendency.
This is important because it can help traders identify when the chances of a reversal are highest. When a stock moves outside of its bands, it is much more likely to reverse course than to continue in the same direction. And the further a stock trades outside of its band, the greater the likelihood of a reversal.
This concept is simple, yet exceptionally powerful. By taking a brief look at a stock’s chart, you can quickly determine whether the risk-return profile is in your favor.
Click to EnlargeThe 12-month chart of Mosaic (NYSE:MOS) below illustrates this nicely. Note how all of the significant lower band violations preceded month-long trading rallies in the stock, while breaks of the upper band were followed by weakness.
Trading Band Breaks: Best Practices
Using Bollinger bands involves a degree of nuance. It isn’t as simple as playing for a countertrend move any time a stock moves out of its band. With that in mind, here are six considerations that can help you refine your approach:
- Band violations work best on the downside: Stocks can stay above their upper bands for a much longer duration, and for a larger percentage move, than they typically do on a lower band break. Jumping too early to bet against a stock that has broken its upper band will empty your trading account in short order.
- Even on lower band violations, patience is warranted. The larger the move below the band, and the longer the stock has traded there, the better your odds. Rarely are meaningful band breaks single-day events. The best opportunities often come in the first hour on the second or third day a stock has traded below its lower band. If possible, use these first hour sell-offs to maximize the odds of success. The best entry points occur when you see cascading, large bars on the one-minute chart of a stock that is already below its band — an indication of the final capitulation.
- Bollinger bands tend to be more effective when used with larger, higher-quality companies with established institutional support than they do with smaller, lesser-known names.
- Stocks that have moved above or below their bands due to news events, such as earnings reports, downgrades, etc., can present opportunities, but the reversal is usually less profitable than it is with a stock that breaks its bands without the benefit of news.
- Bollinger bands work best when used in conjunction with other technical indicators, such as stochastics, moving averages and traditional chart-pattern analysis. The stronger the confirmation from other sources, the greater the odds of success on a particular trade.
- Keep a daily watch list of stocks that have already moved outside of their bands, or are on the verge of doing so.
Stockcharts.com provides a daily list of stocks that have tripped certain technical milestones such as Bollinger band violations.
Bollinger Bands: An Early Warning System
Bollinger bands aren’t just useful for their ability to create trading opportunities; they can also flash an important warning signal in two key scenarios.
Click to EnlargeThe first is a stock that’s plummeting but hugging its band all the way down without significantly breaking it. This is the hallmark of the proverbial “falling knife.” Consider this chart of Ingersoll Rand (NYSE:IR), where the decline in the stock price in conjunction with the persistent drop in the lower band served as an indication that buying the dip was a dangerous proposition:
Click to EnlargeThis works on the flip side as well. When a stock is hugging its band on the way up, the chart is flashing a warning that the odds are heavily against the trader who tries to step in front of the train by getting short. The recent performance of Apple (NASDAQ:AAPL) serves as a prime example.
The second way Bollinger bands provide an early warning is by signaling the unsustainability of a relief rally. If a stock bounces following a decline, but the rally isn’t confirmed by an upward turn in the lower band, it’s likely there’s trouble ahead. Think about a stock in this situation as being similar to Wile E. Coyote when he stands in midair for a few moments after going over the cliff: unsupported, and destined to fall.
Click to EnlargeAgain, Ingersoll Rand provides an example. Note how the initial rally from the late July-early August decline was accompanied by a continued downtrend in the lower band. This was a signal that the upturn was just a dead-cat bounce and was vulnerable to a reversal. The stock experienced a secondary decline of about 15% after this initial move, and only bottomed for good once the lower band finally began to turn higher.
Conversely, the opposite setup is much less effective. When a stock begins to fall even as the band continues to rise, the signal is much less reliable and should generally be ignored. Using this pattern as a cue to buy can work occasionally, but it can also leave you exposed to significant downside.
The Bottom Line
No indicator is perfect, of course, and Bollinger bands can provide their share of false signals. But learning the nuances of bands is one of the best ways you can hit the critical goal of raising your batting average over time.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.