The Bollinger Bands
John Bollinger introduced Bollinger Bands (BB) in the 1980s, making it one of the most beneficial technical analysis indicators available. BB is used to recognize when prices are overbought or oversold, where traders may sell when the price touches the top of the band and buy when it reaches the bottom.
The BB has 3 components:
The standard deviation (SD) is a statistical measure which quantifies how much the values of a particular variable differ from its average. In finance, the SD of a stock’s price reflects its volatility – if the SD is 12%, then this suggests that there is considerable volatility in said stock.
In BB, the standard deviation is used with the 20-day SMA to generate the upper band, which is calculated by multiplying the SD by 2 and adding it to the average.
For instance, the 20-day SMA is 7800, along with an SD of 75 (or 0.96%). Adding two SDs yields 7950, while subtracting two equates to 7650.
We now have the pieces that make up the BB. All that is left to do is to put them together.
Statistically speaking, the current market price should be near the average of 7800. If it is approximately 7950, this could be deemed too costly in comparison to the mean; thus, one should seek out shorting prospects and anticipate a decrease back to its ordinary price.
That is why it would be a good decision to unload at 7950 and aim for 7800.
At the current market price of around 7650, it is viewed as a great deal compared to average prices. One should think about investing as a way to speculate that prices will return to their former level.
Buying at 7650 makes the most sense, with an objective of reaching 7800.
Once the upper or lower bands are hit, a trade can be opened.
I circled with a down arrow all the sell signals BB produced, and they performed quite well; however, at one point, the price stayed close to the upper band and even extended it – this is known as an envelope expansion.
The BB’s upper and lower bands form an envelope, which stretches when the price moves in one direction, signalling strength. This tells us that while BB can work well in range-bound markets, it is not as successful when there is a trend.
Whenever I use BB, I anticipate seeing the trade commence in my favour shortly. If not, I begin verifying whether an envelope expansion may be possible.
There is a seemingly limitless number of technical indicators that exist, but it is not necessary for traders to know all of them. Although being familiar with them can be beneficial, they should never be the primary source when conducting analysis.
I have personally encountered numerous aspiring traders who invest considerable amounts of time and effort in gaining knowledge about various indicators, but this is not beneficial in the long run. A working understanding of a few fundamental indicators, those discussed in this module, will suffice.
We started constructing a checklist in earlier chapters that would help direct the trader on deciding when to purchase or sell. It is now time to revisit this list.
Traders can use indicators as a tool to confirm their trading decisions; they should always look at what the indicators are indicating before committing to buy or sell. It is not necessary to rely solely on support and resistance, volumes or candlestick patterns, but it is still useful to be aware of what the basics suggest. To this end, I’d recommend adding indicators to the checklist, with a slight adjustment that I will explain shortly. Here is the updated list:
The sub-bullet points under indicators are where the twist lies.
You may ponder a situation in which you have the chance to get shares of Bank of India. One day, the bank shapes a bullish hammer, and if all criteria meet expectations, then you can go ahead with the investment.
I am satisfied with all four criteria on the checklist, so I am placing an order to buy 500 shares of Bank of India.
Visualise a case where the initial three criteria have been fulfilled, but the 4th one (indicators should back it up) is not verified. What do you believe would be the best approach?
I think it’s still a good idea to purchase, though I will be reducing the number of shares from 500 to 300.
This is how one should use the indicators.
Once Indicators are verified, I raise my bet size; however, even if they are not validated, I still choose to buy but adjust the bet size downwards.
In other words, for the first three checklist points in particular, I won’t be making any decisive call on buying unless a bullish hammer’s low precisely aligns with existing levels of support; if that’s not the case, it might be wise to think twice before jumping into a trade and consider alternate opportunities.
I pay attention to what the indicators show, but they don’t guide my decisions. If they line up with my plan, I may increase the bet size; regardless, I’ll proceed as intended.