By Timothy McCready – Bollinger bands® (BB) are one of the most popular indicators available to the trading community. Ironically, even with that popularity, most traders remain fuzzy on how to best use the bands and other indicators derived from them.
A large part of the confusion surrounding the Bollinger indicators is directly related to the broad misunderstanding about the basis of all technical indicators. Much could (indeed, should) be said about the nature of technical indicators, but for now I’ll make two points:
1.Technical indicators do NOT predict the future. Technical indicators DESCRIBE current and past activity. They describe that activity in a way that simplifies the presentation of price data, making it easier for humans to understand a stock’s behavior. When you understand how a stock has been behaving, you can make an educated guess about what it will do in the near future.
2.As a result of their descriptive nature, the Bollinger indicator (and others) is useful in scanning large numbers of stocks, helping the trader narrow his/her list of trading candidates to a manageable number.
With that understanding in mind, how do Bollinger bands describe the market? How can we use them in our trading?
First, let’s recognize there are several different Bollinger indicators:
1.the basic Bollinger bands,
2.the %b indicator, and
3.the Bandwidth indicator
For this short article, we’ll focus on the use of the standard Bollinger bands since the %b and Bandwidth indicators are derived from the BB indicator, and are typically used in conjunction with the standard bands.
Graphically, Bollinger bands show on a chart as two lines which embrace the bulk of the price activity; there is an upper band, and a lower band, both of which center on a simple moving average. The math is a bit complex, and not necessary for the normal trader to deal with – just understand that the bands get wider as price activity becomes more volatile and narrower as things calm down.
The intent behind the Bollinger indicators is to capture most of the price action between the upper and lower boundary. In this way, we can quickly and visually identify when something extraordinary is happening – when price action extends above or below that ‘normal’ region.
One of the first ways traders may take advantage of Bollinger bands is to fade any move that bumps into one band or the other. Figuring that if the bulk of closing prices should be inside the bands, any move outside of the normal territory could be overstretched and ready for a snap back. For example: if ABC stock closed ABOVE the upper BB today, a trader might reason that the stock is overbought and so ready for a pullback. In that case, he might look for an opportunity to short ABC.
A second angle a trader could take in his use of the Bollinger band indicator is to look at closes outside of the normal area between bands as the initial thrust of a breakout. From this perspective, the trader could reason that a sharp move outside the bands indicates a significant change in market sentiment – buyers are suddenly much hungrier for the stock, OR stock owners have become desperate to get rid of their shares. Either way, if a substantial shift in market demand has occurred, the price could be making a big move and the trader who has been tipped off by a close outside the Bollinger bands can be positioned to profit nicely from the new imbalance.
Here’s a third angle: since the Bollinger indicator expands and contracts with market volatility, the alert (and patient) trader can identify stocks which are currently experiencing lower than normal price movement. Since price volatility tends to swing from high to low and back to high again, a period of lower than normal volatility (signaled by a narrow ‘bottle-neck’ in the bands) can point our attention to a stock which is about to make a big move. It’s outside the scope of this article to cover the ways we can set a trap for such an impending move, but suffice it to say these situations can be very profitable.
So you see there are multiple ways to use the Bollinger band indicator to take money out of the market. If you put this indicator into play with a solid trading plan, you can be one of the few traders who actually employ it successfully.
Good luck, and above all – stay timid!
Timothy McCready
About the Author
An avid trader of multiple financial markest, Timothy McCready (also known as Timorous on his website) is also very mindful of the dangers presented by trading without proper education or a definite plan. He shares his thoughts on the markets so that other traders can profit without putting their hard earned capital at risk. Readers can get access (without charge) to his workbook: “How to Make Your Own Trading Plan” at http://www.TimorousTrader.com/.
