Sachin has recently started investing in the stock market but is not quite familiar with the factors that influence price movement. Sachin begins to monitor a company’s shares to make sure they are going up and whether he should buy his shares. Over the past 5 days, the stock has shown an upward movement, convincing Sachin that it will rise.
Sachin buys 100 shares, but the share starts to fall and shows a downtrend from the next day. In just 4 days, Sachin loses more than half of his invested amount and sells in a panic, trying to cut his losses further. However, the stock starts to climb again the day after the sale and increases by 30% in value in two weeks. If Sachin had stayed invested, he would have increased the value of his investment by 30%, rather than losing more than half.
The above example is common among amateur investors who mistake a correction for a bear market and sell their stocks in a panic. If Sachin were an experienced investor, he would not have made a loss but would have known that the stock price would rise over time. But how? How do professional investors know when to buy, sell, hold and what are the current or future trends?
The answer is technical analysis.
What is technical analysis?
Technical analysis is the art of forecasting trading opportunities by analyzing statistical trends. This form of analysis believes that whether you’re talking about fundamentals, news feeds, or earnings surprises, they’re all in price and volume. Hence, you don’t need to pay attention to all those balance sheets and income statements. Just identify the pattern and extrapolate to the future, and you have a trading strategy right in front of you. Technical analysis does not give too much weight to fundamentals because it believes that everything comes at a price.
However, technical analysis consists of many tools that these investors use to predict price movement and the effect of volatility on a stock. One such widely used technical analysis tool is Bollinger Bands.
What are Bollinger Bands?
Bollinger bands are a tool used by investors in the process of technical analysis. This tool was developed by a famous technical trader named John Bollinger. Bollinger bands are defined by a set of trend lines drawn two deviations from a simple moving average (SMA) of the price of a stock.
These trend lines can be set positively or negatively and adjusted according to user preferences. The main purpose of Bollinger Bands is to effectively identify when a stock is oversold or overbought. As these two factors can influence the price by a huge margin, investors can use Bollinger Bands to ensure that they enter or exit the market at the right time.
How to use Bollinger bands?
The formula for calculating the Bollinger bands is as follows:
BOLU = MA (TP, n) + m â Ï[TP,n]
BOLD = MA (TP, n) âm â Ï[TPn[TPn[TPn[TPn
If you want to calculate Bollinger Bands, you need to understand moving averages first.
Moving averages: Moving averages are perhaps one of the most commonly used tools for technical analysis. It does not predict the direction of the price but sets the current direction with an offset. This is why they are called âlaggingâ indicators.
Moving averages work well when prices are in the trend. However, you have to be careful because the tool can give a false signal when the prices are not trending. For short term trends one can use 5, 11 and 21 day moving averages, while for the medium / intermediate term 21 to 100 days is generally considered a good metric. Finally, any moving average that uses 100 days or more can consider a measure of long-term momentum. The shorter the MA, the more sensitive the signal.
With a base set in moving averages, you can follow the three steps below to calculate and use Bollinger Bands:
Step 1: The moving average of the closing price is the first and the middle trendline of the Bollinger Band. For example, you can find the closing prices of a stock for 20 consecutive days and divide them by 20 to calculate the 20-day moving average.
2nd step: The second trend line is the upper Bollinger Band. To calculate it, you add standard deviations to the moving average of the stock. Standard deviation measures the distance between numbers and the average closing price of the stock. For example, the formula for the upper band is MOV20 + (2 * 20 Standard Deviation of Close).
Step 3: The third trend line is the lower Bollinger Band. To calculate this, you subtract the standard deviations from the moving average of the stock. For example, the formula for the lower band is MOV20- (2 * 20 Standard Deviation of Close).
How to interpret Bollinger bands?
You can interpret Bollinger Bands through the following points:
- A large price change is expected at the time of volatility if the bands tighten and come closer. If this happens, the stock can start to move in a trend.
- If the bands move away from each other, it may indicate that volatility is increasing and the current trend may stop.
- Investors can identify potential profit targets using the band envelope. This means that stock prices tend to rebound from band to band, which investors use to make profits. For example, if the price moves from the upper band to the MA, the lower band may be the price target.
- Sometimes the price can hug or exceed the tape envelope for a long time. Investors can use this indicator to adjust their current positions or take a new one.
- If the price breaks out of the two price brackets, a strong trend should continue. However, investors need to ensure that prices do not immediately retreat inside the band. If this happens, the strength of the trend may weaken.
Bollinger bands can be a great way for you to predict a stock’s price movement and market trend. As it helps investors identify the stock price target, it can be used effectively to buy / sell / adjust positions and ensure entry and exit is only while making a profit.
However, Bollinger Bands are based entirely on theory and can give you false indicators of price movement. First you need to use various other indicators available and see which one works best for you. You can check out the IIFR to better understand how to use Bollinger Bands.
Frequently Asked Questions
Q.1: What are the uptrends in day trading with Bollinger Bands?
Answer: The uptrend in day trading occurs when you make an intraday trade using information from the Bollinger Bands. As Bollinger Bands can help you assess the market trend, you can use it for intraday trading.
Q.2: What are the components of Bollinger Bands?
Reply : The components of Bollinger Bands are:
- Upper Bollinger Band
- Lower Bollinger Band
- Moving average
- Number of days in a calming period
- Number of standard deviations
- Standard deviation over the last ‘n’ periods of the target price.