Why Bollinger Bands are Essential

If you pull a rubber band too far, too tight, what happens?

It eventually snaps back, or reverts to mean.

Well, the same thing happens with stocks.

If s a stock, index, or ETF moves too high or too low, it can typically snap back, just like a rubber band. One way to tell if a rubber band is pulled too tight in one direction is by keeping an eye on Bollinger Bands (2,20). Technically, with Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands.

They consist of three bands:

  • A simple moving average (SMA) in the middle
  • An upper band (SMA plus 2 standard deviations)
  • A lower band (SMA minus 2 standard deviations)

So for example when we refer to (2,20) we’re referring to two standard deviations above and below the 20-day moving average.

In Plain English, what the Bands tell us is just how far we can pull our “rubber band” before it begins to pull back or revert to mean.  Typically, when the upper Band is hit or penetrated to the upside, we can begin to make an argument the rubber band has been stretched too far north.  When the lower Band is hit or penetrated, we can begin to make an argument that the stock could be about to pivot higher from an oversold point.

For example, let’s look at AT&T (T).

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Notice what happens about 80% of the time when the lower or upper Bollinger Band is touched or penetrated.  We begin to see a pivot in the opposite direction.  We can then strengthen our argument for potential reversal by also confirming with other momentum indicators, such as RSI and W%R.

We can even look at the Dow Jones Industrials, too.

Notice what happens at the lower and upper Bollinger Bands when also confirmed with RSI and W%R. The market begins to pivot and move in the opposite direction.

What’s nice about the Bands with other confirming indicators is that it can tell us how optimistic or pessimistic the herd has – or is becoming. By monitoring such indicators, we can become even more successful as short- and long-term traders and investors.

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