Today, we’ll continue with another mailbag issue. If you missed yesterday’s, you can catch up right here.

Here’s a question on Bollinger Bands…

Hi Larry, your newsletter is much appreciated. There’s so much information and useful explanations that really help build knowledge over time! I have experimented with Bollinger Bands and either an 8- or 13-price regression range in my day trading.

For the Bollinger Bands, I’ve selected one standard deviation rather than the two standard deviations you’ve discussed. (On the shorter time frame, the narrower band seems to work better.) Would you be kind enough to give me any feedback about my attack plan?

– Dave T.

Hi Dave, thanks for your question about Bollinger Bands. They are a popular technical tool for traders.

I can’t offer personalized advice, but I can offer some general thoughts about how traders can use Bollinger Bands to boost their trading.

One of the key things that traders try to identify from a chart is whether a stock price is cheap or expensive. Knowing that information is extremely useful.

After all, if a stock is cheap, then a trader could potentially profit by entering a long position. Likewise, an expensive stock could reveal an opportunity for a short trade to profit from a fall in price.

However, a stock’s price in isolation isn’t enough information on which to base a trade.

Bollinger Bands fit into the picture by adding another layer to that price information…

Price Over Time

Bollinger Bands are great at showing how the current price relates to previous prices – or more specifically, how the current price relates to the stock’s average price over the last 20 days.

Bollinger Bands do this by plotting a simple 20-day moving average (MA) that identifies the average price and trend over the previous 20 days.

Upper and lower bands then identify a typical trading range, as you can see in the chart of the SPDR Dow Jones Industrial Average ETF Trust (DIA) below.

Those upper and lower bands (blue lines) on the chart are set at two standard deviations.

(As a reminder, one standard deviation typically holds 68% of a data set, while two standard deviations typically include 95% of a data set.)

In this case, that means the bulk of the price action (95%) should occur within the blue lines.

Take a look at the chart…

SPDR Dow Jones Industrial Average ETF Trust (DIA)

Source: eSignal

Because Bollinger Bands are based on standard deviations of price data (and not a fixed percentage or level), they can help gauge volatility.

Traders can see straight away that volatility is increasing when the bands move further apart, and vice versa.

This can help identify a potential breakout move, as volatility often ramps higher when a stock breaks out of a range.

And Bollinger Bands can be especially useful in mean reversion trades…

Using Bollinger Bands With Mean Reversion

Prices typically move in waves – that is, an initial move followed by a pullback. So, a stock trading at an extreme (upper or lower band) will eventually revert to its mean.

And it’s this reversion to the mean that can help us profit.

On the DIA chart, you can see numerous examples of where the stock price reverts from either the upper or lower blue lines back to the orange line.

However, to help add further confirmation of a potential mean reversion move, traders often add another technical indicator, the Relative Strength Index (RSI).

The RSI helps identify if a stock is overbought (upper grey dashed line) or oversold (lower grey dashed line).

If you can find a stock vulnerable to a correction (using the RSI) that is also trading at its outer range (at the upper or lower Bollinger Band), then you can really put the odds of a successful mean reversion trade in your favor…

Look at the chart again. I’ve highlighted three examples (red circles in the RSI) where the two signals combined to set up a strong reversal trade….

SPDR Dow Jones Industrial Average ETF Trust (DIA)

Source: eSignal

In mid-June and late September, the RSI formed a ‘V’ out of oversold territory while DIA was trading at the lower end of its trading range (lower blue line).

And in mid-August, the RSI formed an inverse ‘V’ when DIA was trading right on its upper Bollinger Band.

If you look closely, you can identify plenty of other times when these indicators successfully identified a mean reversion trade.

So, to return to the original question… If Bollinger Bands are new to you, then the default settings (the 20-day MA and two standard deviations) are a good place to start.

Yet traders can certainly experiment with different MA periods and standard deviations. You might find ones that better suit your trading time frame and goals.

Just remember that the overarching goal of our strategy is to identify when a stock is trading at the extremes of its current range (blue lines).

Thanks again for your question, Dave.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

P.S. If you have another question you’d like me to answer in a future essay, then please send it to me at feedback@opportunistictrader.com.