Have you ever gotten burned when a winning trade suddenly reversed course? The technical-analysis tool known as Bollinger Bands can help you evaluate short-term price movements.
Here’s how the bands function—and three ways to put them to work.
Bollinger Bands consist of three elements:
- The central band is formed by a stock’s moving average—measured over a period of hours or days. (I typically rely on a 20-day moving average.)1
- The upper band is commonly set two standard deviations above the moving average.
- The lower band is commonly set two standard deviations below the moving average.
The upper and lower bands together generally contain around 90% of the price action, which is what makes a move outside the bands significant.
When the bands are relatively horizontal and the stock’s price repeatedly tags the upper band, technical analysts may take that as a sign the stock is overbought and therefore ripe for a reversal. Conversely, when the stock bumps along the lower band, it could be a sign the stock is oversold and poised to move higher.
However, some traders make the mistake of treating any contact with either the lower or upper band as a trigger, when in fact the price will often “walk” the band without a clear indication of precisely when to act. Therefore, traders would be wise to look for one of the following three signals.
1. The squeeze
When the gap between the outside bands narrows significantly—seemingly squeezing the price—it signals low volatility (see “Trading a squeeze,” below).
If this persists for an extended period of time, it sets the stage for an increase in volatility and a decisive price move in either direction.
In that event, I set a buy order just above the upper band and a sell-short order just below the lower band, so I’m taking a position whichever way the price moves. Once I’m in the trade, I also use stop orders to help manage my risk, usually just over or under the opposite band. You could also use a trailing-stop order, which will adjust the stop price up or down once your predetermined percentage or point change occurs. If the stock changes direction, the stop price will freeze at its new level—and if the stock then hits the new stop price, it becomes a market order.2
Before you trade the squeeze, though, be sure it’s persisted for a reasonable amount of time. If you’re using a 20-day moving average, for example, you’ll want to see the squeeze hold up for at least four weeks. Otherwise, there might not be enough pent-up volatility to lead to a decisive price move.
Also check to see if there is any news that could explain the squeeze, such as a company being acquired. In such cases, the stock could be range-bound for months pending the completion of the deal, and thus your time might be better spent on more immediately actionable trades.
2. The double bottom
The classic double-bottom pattern resembles a W, because the stock sells off to a low, rallies, then tests the previous low before rising to a new short-term high (see “Trading a double bottom,” below).
While double bottoms typically occur at the end of a downtrend and signal the beginning of a potential uptrend, they’re hard to identify as they’re happening—unless you use Bollinger Bands, which can help identify double bottoms in real time by charting where the two lows reside relative to the lower band.
If the first low touches or dips below the lower band and the second low is above the lower band, it could signal a good time to buy—but consider having an exit strategy in place, such as a stop order placed below the W’s bottom.
3. The breakout
When a stock breaks higher, the upper band may increase too since price and volatility are both increasing. The lower band moves in the opposite direction—again, because volatility is expanding—and will continue to do so as long as there is strong momentum behind the breakout (see “Trading a breakout,” below).
When the momentum starts to wane, the lower band will turn back up. It doesn’t mean the stock will reverse, but it does create some uncertainty. At that point, I tend to take some initial profit and let the rest ride to capture any continued growth. However, I’ll also initiate a trailing stop under the current price to close out my position if it turns lower.
These three signals are just a few of the ways Bollinger Bands can be used to inform your trading, so be sure to investigate additional ways to use this and other trading strategies to your advantage (see “What you can do next,” below).
1Schwab trading clients can customize the moving average and standard deviation settings in StreetSmart Edge. | 2Trailing-stop orders aren’t available on all trading platforms.