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| Bollinger Bands |
What it Is:
Bollinger bands are used as a technical analysis indicator. They are formed by
using a 20-day moving average as a centerline and then tracing two bands, each
one standard deviation wide, on either side of the moving average. By watching
the share price's interaction with these bands, technical analysts try to
forecast price movements.
The bands are named after John Bollinger -- a well-known
commentator and technical analyst. Bollinger built his work
on a foundation laid by an influential researcher named Hurst, who discussed
"trading envelopes." Hurst put these so-called "envelopes"
around a stock (or index), surrounding it with a fixed percentage -- such as 3%
or 4%. He noted that trading opportunities often arose when the stock reached
one end of the envelope and then began to reverse.
Bollinger improved on this envelope theory by making it dynamic rather than
fixed. He used a 20-period moving average, and then created bands that were
based on standard deviations.
How it Works:
When a stock moves outside the upper-end of a Bollinger band, it is considered
"overbought." In other words, it has gone up too far, too fast. Such
stocks are often vulnerable to profit taking. Conversely, when a stock drops
below the lower band, it is considered "oversold." An oversold stock
has gone down too far, too fast. These stocks often bounce higher when
bargain-hunters jump in and purchase the shares
Traders often rely on several major principles related to Bollinger bands:
1. The bottom or top of the band is likely to provide support or
resistance, just like a "horizontal" support or resistance level. In
many cases, support or resistance can also be found at the 20-period moving
average, which marks the center of the band.
2. If a stock continues to close outside the band, this is a continuation
signal. In other words, the shares are likely to continue trading in the same
direction.
4. A narrowing of the bands suggests that the next move will be a volatile
one. Swing traders should watch a stock with narrow bands carefully to identify
the breakout from resistance or breakdown from support. This breakout or
breakdown can often yield a profitable trade.
5. Prices can often "ride" the band. Riding an upper band
indicates strength; riding the lower band shows weakness.
The chart below illustrates several Bollinger band principles. Note that for
much of the uptrend, prices rode the upper band. Next, the stock went from
outside the upper band to outside the lower band. It also closed outside the
lower band -- a continuation signal.
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Why it Matters:
Bollinger bands are an
important technical tool for the trader that can help refine judgments based on
classical technical analysis and indicators. When analyzing a chart, the five
principles described above should be carefully applied. If used correctly,
Bollinger bands could tell a swing trader when he or she should buy or sell a
particular security.
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