Almost all of the sample trading ideas I generate for my weekly newsletter involve the use of Bollinger bands. For me, they are an essential tool of swing trading analysis and decision making.
Bollinger bands are named after the well-known commentator John Bollinger -- technical analyst for FNN, the T.V. station acquired by CNBC.
Bollinger built his work on a foundation laid by an influential researcher named Hurst, who talked about "trading envelopes." Hurst put so-called "envelopes" around a stock or index, surrounding it with a fixed percentage amount such as 3 or 4%. He then noted that trading opportunities often occurred when the stock reached one or the other end of the envelope and then began to reverse.
Bollinger improved on this envelope theory by making it dynamic rather than fixed. He used a 20-period moving average and then created bands that were two standard deviations wide. If you think back to statistics, remember that two standard deviations encompass 95% of the instances in any normal distribution.
When a stock is outside the upper end of a Bollinger band it is considered "overbought." I define overbought as a stock that has gone up too far, too fast. It is vulnerable to profit taking. A stock outside the lower band is "oversold." An oversold stock has gone down too far too fast. It is susceptible to bargain hunting. Eventually an oversold or overbought stock is apt to reverse course.
To ensure a stock is truly overbought or oversold, I like to filter the Bollinger band with a momentum indicator such as CCI, stochastics or RSI. In my experience the bands always give meaningful information no matter what time frame the chart is that they are placed on: weekly, daily, hourly, or even five-minute.
There are several major trading principles of the Bollinger bands for use in swing trading:
- The bottom or upper end of the band is likely to provide support or resistance just like a "horizontal" support or resistance level. Support and resistance in many cases can also be found at the 20-period moving average, which marks the center of the band.
- If a stock continues to close outside the band, this is a continuation signal. The shares are likely to continue trading in that very same direction.
When a particular stock reverses after close outside the band, it often retreats to the opposite band before finding support. - A narrowing of the bands suggests that the next move will be a volatile one. Swing traders should watch a stock with narrow bands carefully and identify the breakout from resistance or breakdown from support. This breakout or breakdown can often be bought for a profitable trade.
- Prices can often "ride" the band. Riding an upper band indicates strength; riding the lower band shows weakness.
Now let's analyze the Bollinger bands on the Robert Half International (RHI) chart to see how they could have helped in swing trading decision-making. Bollinger bands combine very well with many technical analysis tools such as candlesticks, price pattern analysis, moving averages and indicators to allow precise swing trading analysis. They are an essential part of my "multiple-indicator" approach to trading. I've labeled nine different points on the chart. Note how RHI moved from one end of the band at point #1 to the other end at point #5. I have labeled points #1 and #5 on the indicators as well.
Below you will find a brief analysis of each of the aforementioned nine points:
- RHI is deeply oversold. It's outside the lower band and stochastics and CCI are giving oversold readings. Shortly after, numerous indicators, including moving average crossovers, begin to give buy signals.
- The price has hit resistance at the upper end of the band. The shares sell off a bit and then consolidate.
- The bands have narrowed dramatically compared to where they were before. A breakout should be expected.
- RHI breaks out of the consolidation on relatively high volume. It spurts from $18 to well over $20 in just two days.
- RHI now closes outside the band. RSI, CCI and stochastics are all very overbought. The stock has gone from one extreme of the band to the other.
- After several negative candles, the trend-following MACD gives a sell signal.
- Note how the 20-day moving average "rides herd," as I call it, on the price, providing resistance to rallies in the downtrend.
- Here we have another close outside the Bollinger band. It is made on a doji candle, suggesting supply/demand equilibrium. Stochastics, CCI, RSI and MACD all give buy signals. Shorts should cover. The stock is not, however, strong enough to go long on.
- Several days later, RHI hits resistance at the declining 20-day moving average. The recovery trendline is broken. Stochastics rolls over. RSI peaks and begins to trend down. A new short position may be initiated.
Good trading!
