Almost all of the sample trading ideas I generate for my weekly newsletter involve the use of Bollinger bands. For me, they are an essential tool of swing trading analysis and decision making.
Bollinger bands are named after the well-known commentator John Bollinger -- technical analyst for FNN, the T.V. station acquired by CNBC.
Bollinger built his work on a foundation laid by an influential researcher named Hurst, who talked about "trading envelopes." Hurst put so-called "envelopes" around a stock or index, surrounding it with a fixed percentage amount such as 3 or 4%. He then noted that trading opportunities often occurred when the stock reached one or the other end of the envelope and then began to reverse.
Bollinger improved on this envelope theory by making it dynamic rather than fixed. He used a 20-period moving average and then created bands that were two standard deviations wide. If you think back to statistics, remember that two standard deviations encompass 95% of the instances in any normal distribution.
When a stock is outside the upper end of a Bollinger band it is considered "overbought." I define overbought as a stock that has gone up too far, too fast. It is vulnerable to profit taking. A stock outside the lower band is "oversold." An oversold stock has gone down too far too fast. It is susceptible to bargain hunting. Eventually an oversold or overbought stock is apt to reverse course.
To ensure a stock is truly overbought or oversold, I like to filter the Bollinger band with a momentum indicator such as CCI, stochastics or RSI. In my experience the bands always give meaningful information no matter what time frame the chart is that they are placed on: weekly, daily, hourly, or even five-minute.
There are several major trading principles of the Bollinger bands for use in swing trading:
Now let's analyze the Bollinger bands on the Robert Half International (RHI) chart to see how they could have helped in swing trading decision-making. Bollinger bands combine very well with many technical analysis tools such as candlesticks, price pattern analysis, moving averages and indicators to allow precise swing trading analysis. They are an essential part of my "multiple-indicator" approach to trading. I've labeled nine different points on the chart. Note how RHI moved from one end of the band at point #1 to the other end at point #5. I have labeled points #1 and #5 on the indicators as well.
Below you will find a brief analysis of each of the aforementioned nine points:
Good trading!