by Daniel Putnam | March 2, 2012 6:30 am
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.
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.
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:
Stockcharts.com provides a daily list of stocks that have tripped certain technical milestones such as Bollinger band violations.
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.
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.
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