- Bollinger Bands® are a widely used indicator for short-term traders.
- They can help you assess the relative strength of a security.
- Active buy and sell signals can be generated.
It can be hard sometimes to know if the price is "right." Is a stock that is trading at $50 a share high, or is it low? 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, exchange-traded fund, or other investment opportunity. You can even apply this indicator to the broad market.
Currently, Bollinger Bands suggest that stocks, broadly speaking, may be expensive on a short-term basis (more on this shortly). 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
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.
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), it generates a buy signal. When it breaks below the lower band (a support level), it’s a sell signal.
Currently, the S&P 500® Index is in the upper part of the band (see the chart below), which according to Bollinger suggests that US stocks are overvalued on a short-term basis. However, if the S&P were to break above the line that forms the top of the upper band, it would be a buy signal, according to Bollinger Band analysis.
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.
A Bollinger Band "squeeze" occurs when volatility reaches a relative low. 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. In the S&P chart above, the Bollinger Bands narrowed, or squeezed in late 2017, and there was a large price increase in early January 2018, followed by the steep decline in late January/early February. Currently, the bands are not in a squeeze pattern, suggesting there may not be a significant move to the upside or downside over the short term.
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 generate 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 to decide when.
Next steps to consider
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