Sachin buys 100 shares of the stock, but the stock starts falling and showing a downtrend from the next day. In just 4 days, Sachin loses more than half of his invested amount and sells in panic, trying to cut his losses further. However, the stock starts to climb again from the next day of selling and increases 30% in value in two weeks. If Sachin had stayed invested, he would have increased his investment value by 30%, rather than losing more than half.
The above example is common with amateur investors who mistake a correction with a bear market and panic-sell their shares. If Sachin was an experienced investor, he wouldn’t have realized losses but would have known that the stock price would go up in some time. But how? How do professional investors know when to buy, sell, hold, and about 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 talk about fundamentals, news flows, or earnings surprises, they are all in price and volume. Therefore, 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 weightage to fundamentals as it believes that everything is at the price.
However, the technical analysis consists of numerous tools that these investors use to predict the 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 trendlines that are plotted two deviations away from an SMA (Simple Moving Average) of a stock’s price.
These trendlines can be set positively or negatively and adjusted according to the user preference. The main aim of the Bollinger Bands is to identify when a stock is being oversold or overbought effectively. As both these factors can influence the price by a huge margin, investors can use Bollinger Bands to ensure 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:
If you want to calculate Bollinger Bands, you must first understand moving averages.
Moving Averages: Perhaps one of the most commonly used tools for technical analysis is moving averages. It does not predict the price direction but defines the current direction with a lag. That’s why they are called ‘’lagging’’ indicators.
Moving averages work well when prices are in trend. However, one needs to be cautious as the tool can give a false signal when prices are not trending. For Short term Trends, one can use 5, 11 & 21-day moving averages, while for the Medium/Intermediate-term, 21 to 100 days is generally considered as a good measure. Finally, any moving average that uses 100 days or more can consider measuring long-term momentum. The shorter the MA, the more sensitive the signal.
With a base set in Moving Averages, you can follow the below three steps 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 it by 20 to calculate the 20-day moving average.
Step 2: The second trendline is the upper Bollinger Band. To calculate it, you add standard deviations to the moving average of the stock. Standard deviation measures how distant numbers are from the average of the closing prices of stock. For example, the formula for the upper band is MOV20+(2*20 Standard Deviation of Close).
Step 3: The third trendline is the lower Bollinger Band. To calculate this, you subtract standard deviations to the moving average of the stock. For example, the formula for the lower band is MOV20-(2*20 Standard Deviation of Close).
How can you interpret Bollinger Bands?
You can interpret Bollinger Bands through the following points:
- A sharp price move is expected at the time of volatility if the bands tighten and get close to each other. If this happens, the stock may begin to move in a trend.
- If the bands move far from each other, it may indicate that the volatility is increasing and the current trend may end.
- Investors can identify potential profit targets by using the band’s envelope. It means that stock prices tend to bounce from one band to the other, 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.
- At times, the price can hug or exceed the band envelope for a long time. Investors can use this indicator to adjust their current positions or take a new one.
- If the price moves out of the two price bands, a strong trend is expected to continue. However, investors should ensure that the prices do not move back immediately inside the band. If it happens, the trend strength may weaken.
However, the Bollinger Bands rely entirely on theory and can give you false indicators about the price movement. You should first use various other indicators available and see which works for you in the best way. You can consult IIFL for any further understanding of how to use Bollinger Bands.
Frequently Asked Questions
Q.1: What is Day Trading Uptrends With Bollinger Bands?
Ans: The day trading uptrend is when you take an intraday trade using Bollinger Bands information. As Bollinger Bands can help you assess the market trend, you can use it to do intraday trading.
Q.2: What Are the Bollinger Bands Components?
Ans: The components of Bollinger Bands are:
- Upper Bollinger Band
- Lower Bollinger Band
- Moving Average
- Number of days in a soothing period
- Number of standard deviations
- Standard deviation over last ‘n’ periods of target price.