A Better Timing Tool for Overbought/Oversold Stocks
Many indicators use arbitrary levels to define high and low values. And arbitrary signal levels can limit the usefulness of any technical indicator.
For example, the Relative Strength Index (RSI) is considered “oversold” when it falls below 30 and “overbought” above 70. These static values fail to consider the market action. In reality, an oversold market can become even more oversold.
Bollinger Bands are an indicator that adapt to the market action to define what “too high” and “too low” mean.
What Are Bollinger Bands?
To put it simply, Bollinger Bands adapt to the most recent market activity. They move higher and lower along with the market. This means overbought and oversold levels will more accurately reflect the reality of what is happening in the market now.
Bollinger Bands are calculated using the standard deviation of recent data. Using daily prices as an example, the first step is to find the 20-day moving average of the closing prices. Then you simply calculate the standard deviation of that average. Default settings are to add 2 standard deviations to the average for the upper Band and subtract 2 standard deviations from the average to find the lower Band.
When the price of the indicator or stock is “oversold,” it will fall to the lower Band and often break below it. When prices rise to the upper Band and above, they are “overbought”. The distance between the Bands expand and contract with the market action, making this technical indicator a useful way to define volatility.
How Traders Use Bollinger Bands
Traders can apply Bollinger Bands to any stock or to any indicator, and for any time frame. Many popular trading programs are capable of showing Bollinger Bands, with varying degrees of changes that traders can make.
They can also be used as a complete trading strategy. Traders buy when the price rises back above the lower Band after closing below that level. Then traders sell when prices fall below the upper Band after closing above it. This simple strategy identified several winning trades in the chart below.
The chart of the PHLX Housing Sector index also shows how the Bands contract and expand. This cycle of contracting and expanding plays out continuously in the markets.
The Bands narrow when prices are in a trading range. This is an indication to traders that volatility is likely to expand soon. Trading the most volatile stocks allows traders to seek the greatest profits in the shortest amount of time.
Why Bollinger Bands Matter To Traders
Traditional momentum indicators sometimes present problems for traders. They could signal that a market is oversold shortly after a powerful uptrend begins, but the indicator may continue to show that the market is oversold until well after the trend has reversed. Bollinger Bands are more adaptive. And for traders, they offer a more reliable timing tool.
Traders also combine other indicators like Moving Average Convergence/Divergence (MACD) with Bollinger Bands. This can help determine the most likely direction of the expected breakout.
Bollinger Bands also offer a way to visualize volatility. Many traders believe that volatility is more cyclical than price. For example, periods of low volatility are followed by periods of high volatility and vice versa. When they see the width of the Bands begin to expand, traders can expect increased volatility in the price to follow. This helps identify the best trading candidates.