Technical analysis is the study of stock prices in an attempt to forecast future price movements. The discipline teaches that all relevant fundamental information is already embedded in the price, therefore, by following price charts, one can increase the odds of a successful investment. There are hundreds of indicators and tools a technical analyst can choose to perform a successful technical analysis, but only one stands out as my favorite.
When evaluating a stock, I often begin with Bollinger Bands. This technical indicator is a way to visually measure volatility by observing whether the price is high or low on a relative basis.
Created by John Bollinger in the early 1980s, the bands are built upon J.M. Hurst's and Marc Chaikin's trading band idea. Simply described, trading bands are moving averages that envelope price on a chart. John Bollinger took this simple concept and developed a statistically-based standard for the bands, designed easy-to-understand trading concepts around them and popularized their use.
All readily available technical analysis software have integrated Bollinger Bands. The standard design for Bollinger Bands is a 20-period simple-moving average with an upper- and lower-moving average, both two deviations away from the 20-period simple moving average. The upper and lower bands provide a visual representation of how far the price has moved away from the average (the 20-period simple-moving average).
How Bollinger Bands work
In their most basic form, Bollinger Bands work by indicating whether a particular price is high or low on a relative basis. It's easy to see whether the price is overextended on the upside or downside by observing if the price bars are touching or piercing either the upper or lower line.
The generally-accepted idea is to enter short if the upper line is hit or pierced, in the belief that price will soon revert back to the mean. If the lower line is hit or pierced, then it is considered a "buy' signal. It's important to remember that the price can remain overextended in both directions for quite a long time. Therefore, Bollinger Bands should not be used solely by themselves as "buy" and "sell" signals.
They work best as confirmation tools for other indicators, such as the fundamental picture. For example, if the price pierces the upper band and other indicators signal bullishness, then the price may continue higher, rather than reverting to the mean. However, if the price pierces the upper band and the other indicators show bearishness, then this is a clear short signal.
The Bollinger Band as a bullish indicator
A good example of a bullish Bollinger Band price action is with the so-called "sin stock" in the tobacco sector, Altria Group Inc. (NYSE: MO). The price has solidly pierced the lower band, signaling it's overextended on the downside and ready for a bounce higher. Moreover, the company is diversifying away from its maligned tobacco core and has increased its dividends year-after-year. Add in an expected revenue increase of 5% in 2013 and the fact that Jim Simon's RenTech hedge fund increased its holdings by 50% last quarter, and shares have a clear bullish bias for the future.
A good example of a "sell" or short candidate through the analysis of a Bollinger Band movement is with Angie's List Inc. (Nasdaq: ANGI), a Web-based locating service for professionals. The stock is exhibiting a bearish Bollinger Band price action. The price piercing the upper band combined with the fundamental picture of increasingly negative net income builds a strong bearish case for this company.
Risks to Consider: It's critical to remember Bollinger Bands are far from foolproof. They need to be used in conjunction with fundamental and sometimes other technical factors to optimize their effectiveness. Never buy or sell a stock based solely on Bollinger Band signals as stocks can remain overextended for long periods of time.
Action to Take --> Bollinger Bands can help investors to pick and analyse price trends in an easy manner. Given the technical and fundamental indicators of both stocks mentioned above, I like Angie's List as a compelling short and Altria as a solid long position.