A key to weathering – and potentially profiting from – a market correction is planning and implementation.
How Bollinger Bands® Can Help With Trading Decisions
Traders are constantly grappling with buy and sell decisions, which is why many active traders set up clear rules. And that’s where Bollinger Bands, an innovation brought to the markets in the 1980s by John Bollinger, can play a key part.
On a chart, Bollinger Bands are depicted above and below a moving average. In the example below, you can see that prices remain within the band range, but sometimes can break through.
The bands are dynamic – expanding and contracting in relation to the volatility of the underlying security. As volatility of the underlying stock or index increases, the distance between the bands widens. As volatility decreases, the bands narrow or contract.
There are two ways to measure volatility – average true range and standard deviation. Bollinger Bands use standard deviation. The common default for the moving average length (middle line in the chart) is 20 periods and the standard deviation (upper and lower lines) is generally set to 2. However, the trader can use any combination that works best for the timeframe being traded.
Using Bollinger Bands
Bollinger Bands are often combined with other indicators to provide more clarity for a potential trade set-up. For example, a trader looking to buy when an indicator reaches an oversold level could look for the price to also be near the lower Bollinger Band, which statistically gives further indication of an oversold condition.
Bollinger Bands are also used to call attention to tight consolidation patterns on a chart. When a stock or index trades with little volatility, for a time the bands will often contract sharply. This reinforces the point that volatility has dried up – a condition that is eventually resolved with a move out of that consolidation.
Note that Bollinger Bands only alert the trader to a condition that precedes a breakout move, but do not indicate the direction of that breakout. Sometimes, these breakout moves can be quite aggressive. This occurs because volatility is cyclical, where quiet periods are followed by periods of greater volatility and vice versa. This ebb-and-flow in volatility is called out by the expansion and contraction of the bands.
“Bollinger Bands have become pretty popular among active traders, and understandably so,” said Brian Bachelier, vice president of active trader strategy for Scottrade. “They can help traders identify entry and exit points into a stock. But these bands, like any band indicator, shouldn’t be used alone or in a vacuum. You’ll need other techniques to help confirm Bollinger Bands.”
Read More: Check out these 7 tools to help you plan your next trade.
The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
The analytical tools, examples and strategies described are for information purposes only and their use does not guarantee a profit. None of the information provided should be considered a recommendation or endorsement of any specific investment, tool or strategy. The choice to use a specific investment tool or strategy should be based solely on your research and evaluation of risks involved, your financial circumstances, and your investment objectives.
More Articles & Insights
A reasoned trading plan can help you overcome your emotions and add discipline to your buy and sell decisions.
Learn about extended hours trading at Scottrade and how trading differs outside normal market hours.