Stock prices don't move in a uniform way. Sometimes the prices move in a tight range and at other times prices go up or down enormously in a short span of time. When prices move within a tight range we say that the stock is less volatile and when prices move up or down quickly we say that the stock has become more volatile. So, traders can make profitable entries when a stock transitions from a period of lesser volatility to a period of higher volatility. However, for that, we need an indicator that can measure volatility and signal when the stock is getting more volatile.
This is exactly what the Bollinger Bands do. Bollinger bands are volatility indicators that give useful insight into the speed with which the price is moving. However, Bollinger bands don't give a buy or sell signal as such like MACD or Moving averages but they can prove immensely useful in combination with other indicators like RSI, MACD, and ADX. Let's dive deeper into this concept and learn the utility of this powerful indicator.
What are Bollinger Bands?
Bollinger bands were developed by an American financial analyst, John Bollinger in the early 1980s to gauge volatility and to identify overbought and oversold conditions.
In a chart, Bollinger bands consist of three lines shown to envelop the price chart. Look at the chart below-
In the chart above, you will notice three lines that contain the price within themselves.
The middle line (shown in red) is a 20-period Simple Moving Average. Then you can see two other lines above and below this 20-period SMA (shown in blue). These lines depict two standard deviation widths from the middle line which is a 20-period SMA. Though you can use any period SMA to draw Bollinger Bands, the default and most used setting is a 20-period SMA.
Now you might ask what is standard deviation?
A standard deviation is a statistical concept that tells how the data are dispersed around a mean. A two-standard deviation, as used in Bollinger Bands, on either side means that 95% of the prices within 20 period time fall within these two bands.
Now that you have a preliminary idea about the Bollinger Bands, let us now jump off to the usage of Bollinger bands in technical analysis.
How to use Bollinger Bands?
To measure Volatility- The width between the two bands depicts the stock price volatility. A narrow width suggests that the stock is less volatile while a wider width between the bands suggests a period of higher volatility. From a trader's perspective, a narrow Bollinger band suggests that the stock is consolidating, and we might see price action once this narrow band starts widening. The price action can be in either direction, up or down.
See how this period of lower and higher volatility looks visually in the chart below.
Some traders use this as a signal. For example, if after a period of contraction, the Bollinger Bands start widening and the price touches the upper band, traders buy the stock. If, however, after a period of contraction the band widens and the price touches the lower band, traders go short and sell the stock.
To signal overbought and oversold levels- Price touching or moving out of the upper Band is construed as an overbought condition while a price going below the lower band suggests the price is overstretched on the downside and the stock is oversold. In such conditions, the price might start returning toward the middle line of the band. This is called reversion to the mean.
However, bear in mind that when prices continuously touch the upper or lower band for an extended period, it means the underlying trend is strong.
See this in the chart below.
In this daily chart of ITC, you would notice that prices after touching upper or lower bands tend to return towards the middle line, as shown by black arrows. Also, notice that in a strong trend, the price remains stuck to the upper band for a prolonged period, as shown by a red arrow.
To set price targets- Some traders use Bollinger bands as price targets. Such traders buy the stock once the price touches the lower band and sell once the price touches the upper band. Conversely, the traders can short-sell once the price touches the upper Bollinger band and exit the position once the price reaches the lower band. Bear in mind though this strategy works best in a sideways market.
As a trend indicator- In a strong uptrend the price remains between the middle and upper Bollinger bands while in a strong downtrend, the prices tend to remain between the middle and lower bands of Bollinger bands.
In the chart above you can appreciate that the price lies between the middle and upper band, suggesting the stock is in strong uptrend.
In these situations, prices crossing the middle band signal a trend reversal or a correction in price. For example, if a stock remained between the upper and middle bands for some time (that is an uptrend) and then later on crosses below the middle line, we would infer that the stock is either correcting or has reversed to a downtrend.
To sum things up, a Bollinger Band is a volatility indicator that depicts the speed with which the price is moving. The indicator can be used to gauge volatility, to set price targets, and to know the trends. Additionally, it also indicates the overbought and oversold regions in a price chart. However, Bollinger Bands are largely used in combination with other indicators like RSI, MACD, and ADX. You can build profitable stock trading strategies using these indicators. In the next post, we will discuss some of the strategies built around Bollinger bands. So, stay tuned !!
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