Foundations: Indicator Review and Bollinger Bands

In last week’s Foundations of Stocks and Options blog which you can read here, we covered indicators and how they can assist and support your chart analysis through the concept of divergence. Now, let’s take a moment to do a quick review of what we have learned about indicators. Simply put, indicators are a numerical calculation based on factors as price action, volume, or the open interest on stock. They are best used as warning signs of impending market change or as support signals for current trades. One of our favorite indicators we like to use on our charts at Tradesmart is the exponential moving average.

​Exponential Moving Average

The exponential moving average or EMA offers a smoothed image of a stock’s prevailing trend. The exponential moving average can provide three main signals trend direction, entry trigger, and support and resistance. When used for trend direction, exponential moving average will indicate if a stock is in bullish, bearish, or sideways trend. A moving average cross is a solid indicator of a buy or sell signal. And depending on where a stock sits on a chart in relation to the exponential moving average lines, the EMA can function as a support line or a resistance line. In short, it is a powerful tool that deserves a place on your stock chart.

However, there is a third indicator that is worth adding to your toolkit: Bollinger Bands.

​Bollinger Bands

Bollinger Bands are an indicator that was developed by John Bollinger in the 1980s. Now, there is a fair amount of math that goes into calculating this indicator. Still, it can be simply broken down as follows: Bollinger Bands are akin to plotting a moving average line which is affected by the volatility of the shares being traded and then applying a line on the top and bottom of the calculated moving average line to create a flexible channel.

The final result of all this math is a system the contains around ninety percent of a stock’s price action. Then when a stock’s price breaks out of the ninety percent range, it is a strong signal for a price shift. It should be noted; we recommend using the following settings when putting Bollinger Bands on your charts.

  • ​Moving Average = 20 Period SMA
  • Band Average = 20
  • Standard Deviation = 2

In closing, indicators are simple to use and a vital part of the trader’s tool kit. We strongly encourage you to explore using the following indicators on your stock charts: the Exponential Moving Average, Stochastics, and Bollinger Bands, as they provide excellent companion information when it comes to executing trades. Finally, please remember these tools offer support to your trading analysis, and you should refrain from making trading decisions based on indicators alone.

If you wish to learn more regarding this topic, please consider signing up for our Foundations of Stocks and Options class, which you can do here. Thank you for reading, and we look forward to seeing you in next week’s Foundations of Stocks and Options blog!