subject: How Useful Are Bollinger Bands In Trading Strategies [print this page] How useful are Bollinger Bands in a trading strategy? Bollinger bands were created in the 1980's by John Bollinger. These bands are basically a moving average with two trading bands above and below the moving average line. The formula used in Bollinger bands adds and subtracts a standard deviation to arrive at an upper and a lower band. The theory behind the bands is that they will move with the volatility of the market. When the market becomes more volatile, the bands will widen. When it is less volatile, then they narrow to a very narrow range.
Bollinger bands work kind of like a rubber band that is being tightened. The tighter the bands get, the more likely it is that there is going to be a change in the trending line. Also, as the price moves to the top of the Bollinger band, it may be an indication of a overbought situation. The closer they move to the bottom line of the band, it may be an indication of an oversold situation.
It is possible for a stock to trade within a range for a period of time. If you watch the price, it will move up and down within the range. There are several different strategies that an investor can use with Bollinger bands. For instance, after a sharp spike or fall in the trend, the market is probably going to consolidate toward the middle of the band. Traders may also use the Bollinger band in conjunction with support and resistance lines to anticipate the action that the stock price will take.
If you are using Bollinger bands with the moving average line, you should watch for a deflection off of the bottom band. As the price moves above the 20 day line, the upper band now becomes the upper price target. The stock prices will probably then fluctuate between the upper band and the 20 day moving average line. Watch for a crossing of the 20 day line. This is probably an indication of a downward trend.
Bollinger bands should be used with other technical indicators to obtain an accurate picture of an expected action. However, you should never use two technical analytic processes to obtain an accurate conjecture. For instance, using two momentum indicators will do little for your analysis. They tend to move together. Avoid colinearity in your analysis.
It is possible for a stock price to break out of a Bollinger band range, and still not be an indicator of a reversal. There are breakouts that do occur. It is possible for a trader to miss out on a great opportunity if they sell merely because the price moved outside of the band. I remember reading an analysis of one stock I was following which indicated that since the price moved above the upper range, it was set for a fall. In this case, the stock price did actually fall, but it may not always be that way.
Bollinger bands use a simple moving average in their calculation based on a default parameter of 20 periods. The 20 periods is merely a default calculation and may not actually represent an accurate picture. A savvy trader may choose to lengthen the number of periods in certain situations.
A trader should also be very careful about making statistical assumptions based on the standard deviations used for Bollinger bands. The sample size used may not be large enough to obtain true statistical significance. In other words, do not put too much into what the Bands are telling you. Always confirm your expectations as indicated above.
Be wise in your investment strategy. You can make money with stock market investments. However, you need to realize that day traders do not always win. Many times they do lose out on opportunities based on what they anticipate the market will do. It is just as difficult to outguess the market as it is to outguess a two year old. Do not let your stock market returns suffer due to unwise decisions.
