What Are Bollinger Bands And How Do I Use Them For Smart Trading?
 

Kenneth J. Dickson

A Favorite Chart Overlay

Just what are Bollinger Bands?

To start with, Bollinger Bands are a convenient tool to have open behind your stock chart at all times. Of course, this is only one of the many technical overlays available to use.

But, I have used it and I have seen good things. If you're just starting out, this would be a good overlay to learn as one of your first.

Should I Customize My Bands?

When you look at Bollinger Bands, you see three lines.

There is one that is near the price. This one is usually a dotted line. This line is the 20 day moving average of the security.

The 20 day setting is the standard used. It was recommended by John Bollinger himself.

If you're a short-term trader or a long term trader, no worries though. He also gave instructions for you:

For short-term trading, use the 10 day moving average. And for long-term trading, use the 50 day moving average.

Not all stocks fit into one of those categories (10, 20, or 50 day) though. You have the option to change the moving average to however long is suitable for the stock you are looking at. And it is good practice to do so.

As you work with them, you will develop a deeper understanding of exactly what are Bollinger Bands.

The Bands In Detail

There is one more thing you must know in order to understand exactly what are Bollinger Bands. That is the two other lines aside from the one I just discussed.

One is above the stock price and the other one is below the stock price.

Same as the middle line, these lines are 20 day Simple Moving Average lines. The difference is that the one above is two standard deviations above the price, while the one below is two standard deviations below the price.

So, those are the basics of what are Bollinger Bands. Now I will get into how to use them for your trading.

Using The Bands As Trading Indicators

It is important to understand what are Bollinger Bands. Equally important is understanding how to use them.

Now, there are a few different ways in which you can use these bands to gauge your trading. Firstly, as you can see, the price of the security is generally between these two bands.

When price goes above or below one of those lines, it is over-extended in that direction. There are a different ways that this can signal a trade. I will go over a few now.

The Double Bottom Buy

I will now go over one of the more advanced ways that Bollinger Bands can be used as a buy signal. It is called the double bottom buy.

Firstly, the stock must be in a down trend.

Secondly, the stock must reach a low and go below the lower Bollinger Band. Its not quite a buy signal yet.

Thirdly, if the second time that the stock makes a low, it doesn't go below the lower Bollinger Band, then it is considered bullish.

This is the set up for the buy signal. You're almost there.

Lastly, the buy signal occurs when the stock rises above the middle line. As you can tell, this trading strategy takes a few indicators and combines them. Because of this it will be harder to spot. But if you do spot it, weigh it more heavily than the other indicators that I will discuss shortly.

If you understand the double bottom buy, you will probably have no problem understanding the double top sell. It has the same set up, except in reverse.

Trading In A Range

One of the simple trading methods involves a trader buying when the stock reaches the lower Bollinger Band and selling when it reaches the higher Bollinger Band.

A few things you must understand:

One, stocks naturally tend to fluctuate being more or less volatile.

Two, when the stock is more volatile, the bands are more expanded.

Because of these two rules, the stock must have little volatility and be trading in a range. Conclusively, this strategy only works once in a while and not for long.

Signaling A New Trend

I will go over one more strategy that may be useful for your trading. This strategy will help you determine if a stock is about to start a new trend.

First, the Bollinger Bands must contract significantly.

Next, you will see the stock break out of one the bands in one direction.

When you see this, you have evidence of a new trend that is about to start. The trend will usually not go in the direction of the breakout. It will go back the other way and break out in that direction. The stock will usually continue in this direction.

One word of caution, if it breaks out too quickly (ex a breakaway) this is not a solid signal and will most likely come back to reasonable level.

If it does break away too quickly, you may want to monetize on this by trading the stock in the opposite direction.

Don't Rely Too Heavily On Indicators

I hope by now you have a better grasp on what are Bollinger Bands, as well as a few ways to use them for trading.

These are strategies that have been developed over the years. As with all technical indicators and trading strategies, they are not correct 100% of the time. With practice, you will develop a strategy and learn which stocks will have the greatest chance of moving in your desired direction.

But, keep in mind that you will never know for sure.

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