By CT Larsen
The Bollinger Band is the closest thing to 'The Holy Grail' oftechnical analysis there is. Especially for large cap stocktraders, it just cannot be beat for analyzing charts. Havingsaid that however, there is probably no other technicalindicator misused or misunderstood as often as the Bolinger Band(BB). This article is to provide the technical analyst with thebasics needed to interpret the many faces of the BB.
Before we begin, let me explain the type of trading done athttp://livingonlargecaps.blogspot.com. We trade large capstocks, we generally hold stocks for less than two months, andmake about 3-5% on an average trade. Done over and over againthroughout the year, we have made over 50% annual returns forthe last three years.
Now lets discuss what the Bollinger Band (BB) is. In itsstandard usage, the BB is derived from taking the 20 day movingaverage of the stock price. And then adding and subtracting twostandard deviations of that stock price and placing a line abovethe moving average and below the moving average. Now withouthaving to re-visit my statistics classes of some 25 years ago, Iwill try to clarify a standard deviation. It is simply ameasurement of how far the price has deviated above or below themoving average. A stock going through a particularly volatilepatch, will see its BB's expand, and a stock going through acalm period, will see them contract.
BB's are available on most charting software. Yahoo has them ontheir technical analysis charts, as do most other web sites thatare dedicated to technical analysis. If you are unfamiliar withthem I urge you to right now, go experiment with them, using afew stocks and market indicators like the Dow, or Nasdaq.
If you are familiar with technical analysis, and use indicatorssuch as the RSI or stochastic. You know one of the unique thingsabout the BB's is they are placed right on the stock charts.They are viewed in the context of the actual price movements. Infact, for me, they define the stock chart. Stock charts tell meway more about future movement with the BB placed on them. Irarely do any analysis without them, except for perhaps aninitial viewing of a stock chart I am considering for watch listplacement. BB's therefore do not give you a number, like mostother indicators, they don't tell you an overbought or oversoldcondition. They just provide a visual, a story, of where a stockhas been. Therefor you have to interpret.
But what can be learned is crucial, to guessing what will happennext. BB's can help you predict price movements, like no othertool. The trick is, to know what to look for. In other articlesI will present what I require a price pattern to look likebefore I even consider it. But for this article, realize thatprice patterns need to be structured, calm, heading up, down orflat. But they can't be erratic. Erratic price patterns arenever worth trading..
If the upper band and the lower band are not moving in unisonthen the pattern is erratic. There is one exception to thisrule, and that is at the beginning of a powerful up or downmove. Remember, the bands tell you where the price will fall inrelative to the 20 day moving average. Well, if a powerful moveis underway, then the price is moving away from the average, andthe bands expand. Once the bands expand it is too late to tradethat move, but the stock is worth watching, one can climb onboard on the next pull back.
But trading the way we do on our blog ,athttp://livingonlargecaps.blogspot.com, that has produced greaterthan 50% return three years running, we like the bands to movein unison. That shows predictability. And predictability iscrucial in getting large returns. It is not the home run we arelooking for, just hit after hit after hit. Load the basesrepeatedly and you generate runs. OK enough baseball analogy.Here is an example, take the chart HIG. With BB's in place lookat the chart in early June 2005. It is just after the powerfulupward move, that occurred in May. First notice in May how theBBs expanded, as the stock shot straight up. Then in June thebands moved in unison. Around mid June the stock touched its 20day moving average, then its formation started to 'bowl' as itmoved up. Buy it here. Once it hits a 5% profit move up asliding stop, and ride the price up. Several things can belearned form this chart. The single most bullish pattern, is astock that has small trading day ranges, and hugs the upperband. It rides it up between the 20 day average, and the topband. The bands are at an upward angle, that is not too steep.And everything moves in unison, both bands, the moving average,and most importantly for profits, the price.
If one should know anything about the stock market, it is this.It is ruled by emotions. Emotions are like springs, they stretchand contract, both for only so long. BB's measure this like noother indicator. A stock, especially widely traded large caps,with all the fundamental research in the world already done,will only lie dormant for so long, and then they will move. Themove after such dormant periods will almost always be in thedirection of the overall trend. If a stock is above it's 200 daymoving average then it is in an uptrend, and the next move willlikely be up as well.
Look at the chart CIT, with the BBs of course. See how in June2005, the BB's contract late in the month. While the pricetouches the lower BB. See how the stock is above the 200 daymoving average. And more importantly the slope of the 200 daymoving average is upward. The stock clearly wants to move up.The bands are ridiculously close together. Buy right here, anoversold stock, moving upward, with narrow bands. What happensnext is the bands expand, I call it fish lips, I love fish lips.This stock could have been bought in June sold at exhaustion asthe bands had expanded with an upper band touch. And thenre-purchased in July and done again. While fish lips provideremarkable entry signals, they generally aren't held as long asthe upward unison movement of HIG mentioned above.
There you have the two most crucial lessons in Bollinger Bands.The HIG pattern I call riding the wave, and the CIT pattern Icall fish lips. Riding the wave can usually be done longer up totwo months, using stops along the way, one doesn't even reallyneed to watch it, of course one can as they ca-ching in onethose safe profits. The other pattern is fish lips, they areusually held for less than a month, and are exited upon upperband touches, or mare exactly retreats from upper band touches.(When the price touches the upper band and then retreats). Fishlips that re formed out of a flat pattern can often turn into'riding the wave,' and then are held longer
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