From time to time, something happens that changes an industry, and by "change" we mean something happens that makes everyone look at the industry in question entirely different. Email changed the way letters were written, and commonplace communication took place, Google changed the way web search was done, the iPhone changed the expectations around cell phones, and companies like Uber and Lyft are changing the way taxi services are rendered. In the world of stock trading, one development that emerged in the early 1980's is Bollinger Bands. While they have been around now for more than 30 years a surprising number of investors and traders still have a minimal understanding of this tool.
If you have been around TradeSmart University much, you should be well acquainted with our five steps of trade confirmation. It is ingrained into our core Foundations of Stocks and Options, and we build all of our training around the concept.
In case you are unfamiliar, the five steps of trade confirmation are as follows:
It is critical to build a framework of where the buying and selling pressure will occur. Typically, we build this with our line drawing techniques, but other techniques such as Ichimoku Clouds can also help establish your support & resistance areas.
"The trend is your friend." Without it a trader is limited to selling options to make income. Identifying trends and entering them early on is a critical key to making money. Typically, we teach trend identification built on moving averages. Other tools one could use is line drawing or overlays such as Ichimoku Clouds still built on moving averages. Whatever the tool, it is critical that you identify the trend.
Chart patterns are little patterns of sentiment that appear on a chart. As you recognize them, they will help you predict better the likely direction the stock is about to move. There are only a handful of patterns, and it is well worth your time to learn them.
Candlestick patterns are similar to chart patterns, but they do not take as long to develop. Within one or two trading sessions, candle patterns can tell you what the likely direction is for the stock you are trading. Like Chart patterns, there are only a handful of signals one needs to learn. But when you do, your trading will never be the same.
Finally, the last step of confirmation is indicators. There are only two reasons to use an indicator: to confirm what you already knew or to alert you to something you did not see. Indicators are a very valuable tool in the confirmation process, so long as they are kept in their proper place.
These five steps of trade confirmation will help you consistently pick more winners and help you be a much better trader and analysts of trades. However, Bollinger Bands can simplify the process even further.
While the five steps of confirmation process is essential for doing a well-rounded analysis, the tools involved can change quite a bit. That's where Bollinger Bands come in to play.
Bollinger Bands can serve to replace or supplement three of the five steps, all on one screen. They can help you:
It is entirely possible to trade from only the Bollinger Bands screen while still having most of the information you need.
One of the unique factors of the Bollinger bands is the relative nature in which they form around a stock. The bands expand and contract with the volatility of the stock. Consequently, it is frequent to see the price pushing into the bands.
A push into an upper or lower band itself is not a representation of support or resistance, however when the price is pushing into one of the bands, and a candlestick reversal pattern appears, at that point, the band starts to function more like a support or resistance.
Because of this unique function, the Bollinger Bands can be used to replace the framework of a stock usually provided by a support & resistance grid. The advantage, however, is that the bands are relative rather than absolute. Many a frustrated trader has drawn support & resistance lines only to be frustrated that the stock trades "close" to the grid but not exactly within it.
Bollinger bands are one way to approach this challenge. The relative nature ensures that the bands are constantly changing to conform to the trade. These adjustments to the bands displays for us a logical place for turns to take shape and consequently provide a good framework for the analyst to observe the trade.
In addition to providing a framework, the bands help provide trend clarification. Bollinger bands are built around a moving average. Because of this, the bands naturally have a trend tool built-in. If the stock is above the average it is bullish, and if it is below the average it is bearish.
To bring further clarification to this picture and setup, one could add a seven or ten-day moving average in addition to the Bollinger bands. This would provide a moving average cross signal to help confirm further that the trend has changed.
While providing a framework is very valuable, and certainly identifying the trend is critical, one of the best parts of Bollinger Bands is the signals they directly provide.
There are three signals in particular that we see on Bollinger Bands:
The squeeze is the most popular trade shown by the Bollinger bands. It represents a stock that has become stuck in a period of low volatility. After low volatility comes a high volatility event, one that we can profit from as traders.
Walking the band is the trend trade that shows up when the stock is moving between the upper and middle band or lower and middle band. It represents a trend that is established and moving. As the stock pushes into the band it is showing strength, not weakness.
The Reversal play will appear as the trade is about to reverse and either move sideways often in a channel or completely change direction. Either way, it can provide a high probability trade. Often the reversal play takes the most faith, but it usually provides the highest risk/reward payoff.
While Bollinger bands provide an excellent way to look at the data, they do not by themselves cover all five steps of confirmation. If we are working with a Bollinger based system, we will add a few additional tools for confirmation, which add a fair sense of predictability.
The foundation of the setup are the Bollinger Bands themselves. This provides general structure, trend information, and a few specific trade setups.
Candlesticks are the best friend to a Bollinger Band trader. Some of, if not the most powerful signals that occur on the bands happens when a candlestick reversal appears at a Bollinger point. These signals are very strong and very powerful in predicting the next move.
Chart patterns provide a valuable role in assisting the interpretation of price movement inside Bollinger Bands. While Triple tops and Head and Should patterns may be less obvious, M and W patterns become obvious and provide immediate data as to the likely direction of a trade.
In addition to the basic bands, there are a few indicators that can help bring even further clarity:
Bandwidth is an indicator that takes a measurement of the space between the Bollinger bands and plots it like an oscillator across the bottom of the chart. This indicator will work similarly to an ADX indicator, though with some substantial performance differences.
%B is an oscillator specifically designed to work with the bands. It applies a basic stochastics formula but derives all the data from the bands as opposed to the price of the stock itself. This tool is very valuable in helping to identify confirmations and signals of a reversal.
For the most part, indicators outside of the regular Bollinger suite are not needed; however, the Reversal play becomes much clearer with the addition of a stochastics indicator. This indicator rounds out my Bollinger Toolkit.
From time to time, someone shows up and changes the way we think about things. John Bollinger did this when he created his Bollinger Bands. This powerful tool can help you get a better idea of what structure your stock is trading within, reveal some key trade setup signals, and serve as the foundation of all your analysis. If you have not yet taken the time to learn about Bollinger Bands, take the time to get started today - it will be a worthwhile study.