When you’re starting off as a trader, there are a few tools you want in your tool kit.
Technical indicators are one of them. So today, let’s look at one important indicator that can boost your trading…
Traders use charts to try to identify whether a stock is cheap or expensive.
Knowing that information is extremely useful. After all, if a stock is cheap, then you could profit by entering a long position.
Likewise, an expensive stock could be an opportunity to profit from a fall in price.
However, a stock’s price in isolation isn’t enough information on which to base a trade.
So Bollinger Bands help add another layer to that price information…
Price Over Time
Bollinger Bands are great at showing how the current price relates to previous prices.
More specifically, they show 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).
Upper and lower bands then identify a typical trading range. You can see an example in the chart of the SPDR Dow Jones Industrial Average ETF Trust (DIA) from a couple of years back.
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.
In this case, 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 can help gauge volatility.
You can see that volatility increases when the bands move further apart, and vice versa.
This can help identify a potential breakout move. Volatility often ramps higher when a stock breaks out of a range.
And Bollinger Bands can be especially useful in mean reversion trades…
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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 will eventually revert to its mean.
And this reversion to the mean can help us profit.
On the DIA chart, you can see numerous examples of where the stock price reverts from the upper or lower blue line back to the orange line.
And for further confirmation, traders often add another technical indicator, the Relative Strength Index (RSI).
The RSI helps identify if a stock is overbought (upper gray dashed line) or oversold (lower gray dashed line).
If you can find a stock vulnerable to a correction (using the RSI) that is also trading at its outer range (Bollinger Band), then you 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 reversal trade.
SPDR Dow Jones Industrial Average ETF Trust (DIA)
Source: eSignal
In mid-June and late September 2022, 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.
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 also experiment with different MA periods and standard deviations.
As we discussed with the Moving Average Convergence/Divergence (MACD) technical indicator last week, you might find ones that better suit your trading time frame and goals.
Just remember that the Bollinger Bands’ overarching goal is to identify when a stock is trading at the extremes of its current range.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict