You know you’ve arrived if you’ve had something named for you. It’s safe to say, then, that famed technical trader John Bollinger hit this mark. The creation of his trading indicator, known as Bollinger Bands, has been helping technical analysts maximize profits and minimizing risks for over 30 years now, using the principle of adjustment as the guiding light to increased green. Considering it’s one of the most popular technical analytic techniques out there, it’s safe to say that Bollinger’s handiwork isn’t going away anytime soon.
A Brief History of Bollinger Bands
Back in the 1980s, a veteran market technician named John Bollinger built an indicator technique which utilized a moving average with two trading bands on either side of the average. Through this technique, which was dubbed Bollinger Bands, he (and subsequent traders in the technical analysis game) was able to add and subtract a standard deviation calculation as opposed to a percentage calculation of a moving average.
This standard deviation was key because it allowed investors to measure the volatility of stock to ensure that it wasn’t creating variances away from its actual value. This measurement of price volatility made Bollinger Bands a hit in the market. Today, many investors like using the tool because it enables them to mine nearly all of the price data that is needed between the indicator’s two bands.
How do Bollinger Bands Work?
The primary function of Bollinger Bands lay in its design, which consists of a center line and two price channels, or bands, that are drawn above and below the center. The center line is an exponential moving average, which means that it’s a moving average whose weight is skewed closer to more recent data. The bands, meanwhile, are the standard deviations of the stock that’s being studied. As the price action of a stock becomes more volatile, the bands expand. If the stock transforms into a tight trading pattern, the band’s contract.
Bollinger Bands can be a crucial tool to use on a stock that may be trading for long periods in a trend, with some occasional bouts of volatility. Technical analysts will use the moving average to filter the stock’s price action to spot the trends better and to gain critical information on how the market is trading as a whole. For instance, the market may consolidate after a sharp rise or fall in the trend, reducing it to trade in a narrow fashion and crisscrossing above and below the moving average. The traders will then utilize the Bollinger Bands’ dual price channels as a means to pinpoint this behavior more accurately, since it encompasses the trading activity around the trend.
Bollinger Bands as a Price Indicator
Traditional charts will use various patterns in conjunction with volume to indicate uptrends or downtrends. The patterns will combine moving average with lines of resistance and support to help investors anticipate where stocks may be going. These straight lines are drawn the tops or the bottoms of stock to pick out upper and lower price extremes, and then add parallel lines to define the channel to indicate the range where the prices should move. As long as the stock stays within the parameters of these lines, investors can be pretty confident that the prices are moving as anticipated.
Bollinger Bands let technical analysts know it’s time or sells in a different way. Simply put, when a stock price continually comes in contact with the upper band, the prices are deemed to be overbought, and it’s a good time to think about selling. Conversely, if the stock price is constantly making contact with a lower band, prices are thought to be oversold, which then triggers a buy signal.
The reason why this works is that Bollinger Bands, when being used by investors, designate the respective bands as a price target. Generally speaking, if the price bounces off the lower band and goes above the 20-day average (also known as the middle line), the upper band turn into the high price target. If the uptrend happens to be strong, prices will typically fluctuate between the 20-day moving average and the upper band. When this occurs, a crossing below the 20-day moving average triggers signs of a trend reversal to the downside. This tactic allows traders to spot oversold conditions easier, when could lead to a more efficient way to gain profit when the stock price moves back toward the center moving average line.
“The Bollinger Band Squeeze is a trading strategy designed to find consolidations with decreasing volatility. In its purest form, this strategy is neutral and the ensuing break can be up or down. Chartists, therefore, must employ other aspects of technical analysis to formulate a trading bias to act before the break or confirm the break.” –stockcharts.com
Not Without its Flaws
John Bollinger himself readily acknowledges that his indicator tool was not a buy or sell signal. Rather, it’s a tag. Those that use the tool as a pure signal for action may not find the tool to as effective as other techniques.
As such, it can be argued that the best way to use Bollinger Bands is a technically analytical tool used to monitor trend activity. Because it can produce a sophisticated level of analytical data in an elegant, consolidated way, savvy investors may deem Bollinger Bands to be a very efficient model to paint a complete data on a given stock.
Careful Analysis Could Lead to Wiser Choices
Every strategy has its minuses as well as its pluses, and Bollinger Bands are no exception. One thing that investors should always keep in mind is the market can be tricky to decipher sometimes, and even the most sophisticated tools at an investor’s fingertips aren’t going to lead to the perfect trading decision every time. The best thing that investors can do is to acknowledge this as a fact of Wall Street.
However, the best tools to help minimize the presence of risk as the prospects of profitability increase are ones that smartly focus data in a way that’s logical, sensible, and easy to decipher. And based on the reputation that it’s grown since hitting the scene in the 1980s, it’s safe to say that Bollinger Bands hit the criteria. It also seems safe to say that it will be a tool that investors utilize for the next 30 years, and then some.