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 security. Currently, this indicator is suggesting that stocks, broadly speaking, are overvalued 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
Bollinger Bands look like an envelope that forms an upper and lower band1 around the price of a stock or other security (see the chart below). Between the two 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? Bollinger 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 higher 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 band (see the chart below), which according to Bollinger suggests that U.S. 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,” as Bollinger himself describes it, 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 (see chart above). In the chart immediately above, the squeeze occurs around September 2016, and is followed by an increase in price.
Looking at the previous chart of the S&P 500 (see second chart above), you can see currently that the Bands are relatively wide, suggesting volatility is low. The last squeeze seems to have occurred in September 2016; this was followed by an increase in volatility and a down move in the S&P 500 through October 2016.
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.
- Read more about Bollinger Bands.
- Find out how to identify more technical patterns.
- Create custom charts using active trading tools.
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