Traders often try to use charts to determine whether a stock is cheap or expensive.

After all, if a stock is cheap, then you could profit by entering a long position.

Likewise, an expensive stock could give you the chance for a short trade.

However, a stock’s price in isolation isn’t enough information on which to base a trade. That’s where another tool in our box can come in handy…

Bollinger Bands are a technical tool to help identify trends. And they add another layer to a stock’s price information.

Price Over Time

Bollinger Bands show how a stock’s current price relates to previous prices.

More specifically, they reveal how the current price relates to the average price over the last 20 days.

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

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

SPDR Dow Jones Industrial Average ETF Trust (DIA)

Source: eSignal

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

As a reminder, two standard deviations typically include 95% of a data set. That means the bulk of the price action (95%) should occur within the blue lines.

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

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 this reversion can help us profit.

On the DIA chart, you can see numerous examples of the stock price reverting from the blue lines back to the orange line.

And to confirm a potential 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 the odds of a successful mean reversion trade grow 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 last year, the RSI formed a ‘V’ out of oversold territory while DIA was trading at the lower end of its trading range.

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.

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 experienced traders can also 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 here is to spot when a stock is trading at extremes – and identify a mean reversion trade we can use to profit.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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