After 2021's 28% gain for US stocks—as measured by the S&P 500—the market is off to a negative start in 2022, as of mid-January. Weakened by the Fed moving to withdraw some economic support, along with Omicron ripple effects, lingering supply chain issues, and other factors, stocks are down 4% thus far this year. Will that trend continue?
One technical indicator—Bollinger Bands—suggests that US stocks, broadly speaking, may be oversold on a short-term basis.
Using Bollinger Bands
How do you determine if an individual stock price is relatively high or low? Is a stock that is trading at $50 per share high, or is it low, relative to its recent price range? You may have done your research and decided to buy or sell. But when is the best time to pull the trigger?
Bollinger Bands are one tool that can help you decide when to make your move by illustrating the relative strength—or momentum—of a stock or other investment. You can even apply this indicator to the broad market.
Bollinger Bands look like an envelope that forms an upper and lower band* around the price of a stock or other security (see the chart below). Between the 2 bands is a moving average, typically a 20-day simple moving average (SMA).
Bollinger Bands are plotted at a standard deviation above and below a simple moving average of the price. The upper band is the moving average plus a standard deviation, and the lower band is the moving average less the standard deviation.
How can Bollinger Bands help you determine the relative strength of a stock? John Bollinger, who created this indicator, considers the price of the stock relatively low (attractive) if it is near the lower band, and relatively high (overvalued) if it's near the upper band. Of course, investors should not buy or sell solely based on these signals alone, but they can help assess relative value along with other information.
Buy and sell signals
In addition to these "high" and "low" relative assessments, there are other trading signals that are generated by how the price of the stock or security interacts with the bands. For example, when the stock breaks through the upper band (a resistance level), some traders believe this generates a buy signal. When it breaks below the lower band (a support level), some traders believe this is a sell signal. According to Bollinger, a close either above the band or below the band is not necessarily a reversal signal, but rather a continuation pattern.
Currently, the S&P 500 is at the lower part of the lower band (see Bollinger Bands applied to the S&P 500® Index chart), which suggests US stocks are undervalued on a short-term basis. Some traders would interpret a break below the lower part of the band as a sell signal.
Volatility and the bands
Bollinger Bands can also provide a unique assessment of volatility. Narrowing Bollinger Bands (i.e., when the bands move closer together) could suggest that volatility is decreasing—as investor sentiment potentially becomes more optimistic or complacent. As the chart above shows, the bands have actually widened since late December.
Another pattern of note is a Bollinger Band "squeeze." This occurs when volatility reaches a relative low in the context of recent price action. This squeeze can frequently be followed by a period of increased volatility, and may result in a significant move by the stock to the upside or the downside. A squeeze has not occurred recently.
Advanced use of Bollinger Bands
An advanced application of Bollinger Bands involves another indicator: the relative strength index (RSI). Bollinger Bands can be applied around the RSI line to assess additional buy and sell signals.
When RSI is near an extreme high (~100) or low (~0), and is touching either the high part of the upper band or the low part of the lower band, the RSI line could pull back sharply from the band. Bollinger Band analysis holds that a failure of RSI to touch the upper band on a second try generates a sell signal. At extreme lows, a failure of RSI to reach the lower band triggers a buy signal. This is similar to double top and double bottom patterns, respectively, that can occur for the price. Currently, RSI is not near extreme highs or lows.
Another tool in the toolbox
Applying Bollinger Bands to RSI demonstrates an important lesson when using technical indicators. You should not make an investment decision based only on the signals given by a single indicator or data point. Fortunately, Bollinger Bands can be used in combination with different indicators, like RSI, as well as support and resistance, moving averages, MACD, stochastics, and any other research tools that may support your analysis.
Of course, you should never rely on a single piece of information to make an investment decision. It's always important to consider fundamental stock research and your particular goals, time horizon, and risk tolerance before making an investment decision. You should consider complementing technical analysis with sound fundamental analysis. As it can be said, the fundamentals can tell you what to buy or sell; the technicals can help you decide when.
Next steps to consider
Find new investing ideas and get up-to-the-minute market data.
Learn what you need to know before trading the market.
Learn about more technical indicators and how they can help you trade.