Ask The Trader
Wednesday, May 09, 2001
You guys have referred to Bollinger Bands a few times in your stock updates and I'm wondering how to best use this indicator
When using Bollinger Bands, it's best to think of them as a target. Bollinger Bands were created by none other than John Bollinger and are simply two trading bands placed two standard deviations above and below the 20-dma. Using two standard deviations ensures that 95% of the price data will fall in the middle of the two trading bands. In general, a stock is considered overbought when it hits the top band and is considered oversold when it touches the bottom band.
When I mention using the bands as targets, I mean that if the stock bounces off the lower band and crosses up through the 20- dma, the upper Bollinger Band becomes the price target. Of course the opposite is true in regards to a bounce off the upper band. If the stock is turned back at the upper band and crosses down through the 20-dma, the bottom Bollinger band becomes the next price target.
In a strong uptrend, a stock will usually fluctuate between the upper band and the 20-dma. In this case, a violation of the 20- dma becomes a warning of a trend reversal to the downside.
Bollinger Bands also expand and contract based on the last 20 days' volatility, or price swings. During a volatile period, the distance between the two bands will widen. Visa-versa, when the last 20 trading days have been calm, the bands will contract. There is a tendency for the bands to alternate between tight and wide.
When the bands are unusually wide, that is often a sign that the existing trend may be coming to an end. When the bands are unusually tight, that is usually a sign that a new trend is about to commence.
As with any technical indicator, Bollinger Bands are best utilized in conjunction with at least one other indicator. We like the MACD, but you can also look to the OBV for confirmation of a Bollinger Band buy/sell signal.
Good Luck and Have a Profitable Trading Day
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