2021 has broadly started out on a positive trajectory for investors. The S&P 500 hit new all-time highs this week, as continued government support is expected to keep helping combat the negative economic effects of COVID-19. Although this earnings season is expected to face some negative comparables to the same period a year ago, that dynamic may switch during the remainder of 2021.
Amid the ongoing uncertainty related to the pandemic, one technical indicator suggests investors may want to be cautious over the short term. The Bollinger Band indicator suggests that US stocks, broadly speaking, may be overbought on a short-term basis. 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.
Using Bollinger Bands
It can be difficult for active investors making short-term trades to determine what the short-term trend of the market may be. Similarly, how do you determine if an individual stock price is relatively high or low? Is a stock that is trading at $50 a 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. Bollinger does not believe investors should buy or sell solely based on these signals, but that 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 a number of 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 top of the upper part of the band (see Bollinger Bands applied to the S&P 500® Index chart), which suggests US stocks are overvalued on a short-term basis. However, some investors would interpret a break above the upper part of the band as a buy signal.
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. The bands have narrowed since early December, with volatility decreasing as stocks have crept higher.
A Bollinger Band "squeeze" 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.
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, there are no clear signals given by these indicators for the S&P 500.
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.
Most importantly, 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.