Bollinger bands are a very popular and widely used technical analysis tool by traders. It was developed by a famous technical trader named John Bollinger.
Bollinger bands are made up of two bands, an upper and a lower band. Both bands are derived from a specific simple average formula and both are used in order to identify the volatility of a stock. Bollinger bands adjust themselves to market conditions hence traders use it in timing their buying and selling. So how are Bollinger bands being used in analyzing a stock?
Since Bollinger bands adjust to market conditions, if the stock is volatile, the distance of the two bands increase and it decreases with decreasing volatility. With that being said, traders can identify which stocks will most likely gain significant momentum and will either breakout or breakdown.
Prices never go out of bounds from the Bollinger bands as the two bands adjust with the price movement. In breakouts, stock prices normally hit the upper band successively and sometimes, peep out of the band. Traders can spot a possible breakout when the price consistently hit the upper band even if the distance between the two bands are not significant.
As soon as price momentum starts to weaken, the stock price will go lower from its upper band, which signals traders to exit their positions.
The same can be said on breakdowns or down trends. As soon as the price keeps on hitting the lower band with its closes, it signals a possible breakdown or downward momentum of the price. Traders normally exit their positions at this point and wait for the momentum to weaken and for a bounce.
However, just like most technical analysis patterns and indicators, Bollinger bands doesn’t guarantee 100 percent success rate. There are many times wherein Bollinger bands failed to provide the result that it signaled.
A more efficient way to trade Bollinger bands is to use it along with other indicators in order to come up with a better decision. Many stocks defied Bollinger bands as they failed to breakout despite hitting the upper band consistently and there are also a lot that didn’t go down after it hit the lower band successively.
Indicators that are ideal to use with Bollinger bands are MACD, STS, and RSI. The MACD, or the Moving Average Convergence Divergence, is a trend indicator. Just like Bollinger bands, it uses the concept of simple averages and is made up of two lines of which one is of shorter time frame and the other is of a longer time frame.
The STS on the other hand, or Stochastics, is a leading indicator. A leading indicator normally predicts a trend before it happens thus if STS is positive, the stock will most likely rise. Using STS with Bollinger bands is good when the two bands are close to each other. If the STS shows possible strength and the stock price continues to hit the upper band, it will most likely go higher. The opposite can be said on a down trend.
Lastly, there is the RSI or the Relative Strength Index. RSI simply shows the strength of a trend. The stronger the trend, the steeper the rise or drop of the RSI.
If what the Bollinger bands show coincide with what the indicators show, then the price will most likely move towards where both the Bollinger bands and the indicators point. If there is a difference between the Bollinger bands and the indicators, it is called divergence and normally, the indicators would win. Hence, if indicators show possible bullishness or bearishness, it will most likely happen. However again, it doesn’t work that way all the time.