There are literally 100’s of different technical analysis indicators available to financial market traders. Most every indicator has its adherents and detractors in the market. The reason for this is that every indicator works some of the time. Based on the way indicators are devised, they are fitted to a certain market condition. This is why they sometimes work and sometimes do not work as expected.
As you probably have figured out by now, indicators that only work in certain market conditions are not feasible in the real world of investing. This means that most every indicator is a crap shoot whether it’s going to work or not. If you are investing your hard earned money, you need more certainty than a crap shoot when it comes to making decisions.
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It is important to note that no indicator is foolproof. Every stock market indicator every devised has its faults and drawbacks. Not one should be trusted 100% when making investing decisions. However, some have been proven over time to simply be more effective than others
The good news is that there is one indicator that has proven its worth regardless of market conditions.
This indicator is used across the board in finance from the largest hedge funds and institutions to regular investors. It has become extremely popular yet many investors don’t know how to properly use it to make profitable decisions in the financial markets.
The reason for its widespread popularity is that it is extremely easy to use and is readily available on nearly every on-line trading platform. In addition, the indicator makes plain old common sense. This is critical in this world of more and more esoteric indicators and systems. Simple is often the best policy when it comes to choosing investing tools.
I am referencing Bollinger Bands as this popular and highly effective technical indicator. Bollinger Bands are powerful tools to help assist with investing decisions.
This article will explain the what, how and why of Bollinger Bands and provide 3 tricks to help you use them profitably.
Let’s get started!
Bollinger Bands were designed by John Bollinger in the latter half of the 20th century as a tool to measure volatility. Mr. Bollinger was not the originator of the “trading band” idea. The original idea is credited to J.M. Hurst. Another notable name in the development of this effective technical indicator is Marc Chaiken.
Bollinger Bands consist of nothing more than simple moving averages surrounding price bars on a chart. This means that two moving averages are offset by a certain number of deviations on each side of the actual simple moving average.
I know this may sound complicated, but it really is simple. Don’t worry, by the time this article is finished, you will have a complete understanding!
John Bollinger standardized the trading bands into the well-known standard used today. Bollinger Bands are built from a 20 period Moving Average, an upper moving average set 2 deviations above the simple moving average, and a lower moving average set 2 deviations below the moving average.
While it is not needed to successfully use the Bollinger Bands for making investing decisions, here is the formula behind Bollinger Bands. Investors can use this formula to help program their own automatic trading programs based on the Bands.
Bollinger Bands provide the investor a visual representation determining if price is overextended one way or another in relation to price’s simple moving average.
This means high or low as price relates to the average, which is the middle line or 20-period moving average. It is easy to see if price is overextended one way or another if the price bar pushes or breaks through the upper or lower band.
Bollinger Band Trick # 1
This is the primary way successful traders use Bollinger Bands to make real-time trading decisions. The Bands are used as a “counter trend” indicator. This means that when a price bar hits, or better yet, pierces the upper or lower Bollinger Band, the trader shorts or goes long the stock. If the upper band is touched or pierced, it is a short signal. If it is the lower band, it is a signal to buy the stock.
However, it is critical to note that price can ride the upper or lower band for quite a long time prior to reverting to back to the mean.
Therefore, this shouldn’t be used in and of itself as a buy or sell signal but rather as a confirmation tool for other indicators.
For example, the price bar pierces the upper line, but your other indicator does not confirm the bullish strength— this is a sell trigger.
If the indicator does confirm and you are already in the trade, this is a sign to stay in the trade. The opposite is also true at the lower band.
Bollinger Band Trick #2
Bollinger Band squeezes are a time proven way to make money with the Bands. Whenever the Bollinger Bands narrow into a tight range, it is a signal that a price breakout may soon occur.
The standard way to determine width is on a six-month basis. Don’t worry, there is a tool called Bollinger Bandwidth that is a standard part of most charting platforms. This tool is used to find Bollinger Band squeezes.
The trader locates a Bollinger Band squeeze, then waits for the price to break out above or below the narrow range. The trade is then entered in the same direction as the breakout.
The critical thing to remember is that squeezes do not signal price direction. They indicate a lowering of volatility. It’s crucial to wait for the break out of the squeeze prior to entering the trade directionally.
Years of experience has revealed that once the breakout occurs from a squeeze, price is likely going to move enough of a degree to create profits. This is due to the volatility expansion which is inherent within the breakout.
What I like best about squeezes is that they can be used on any time frame. Long term investors and day traders alike can use the squeeze trick by just changing the chart timeframe.
Bollinger Band Trick #3
Bollinger Band expansions are another trick used by professional traders for making decisions. Bollinger Band expansions occur when the Bollinger Bands expand to a wide level. It is smart to think about Bollinger Band expansion as the opposite of the Bollinger Band squeeze.
Band expansion occurs when there is surging price volatility. When you notice, or when the Bollinger Band width indicator tool signals expansion the Bollinger Bands it signals that the stock is trending in the direction of the expansion. As the Bollinger Band expands, it confirms the price trend in its direction. As the market trends though, any slowdown in price momentum will result in the Bollinger Band which was headed away from the price trend to turn back to the same direction of the price trend.
Using the expansion trick is easy. Enter trades in the direction of the expansion but always be wary of the expansion reversing. Once the expansion starts to reverse, it can signal that it is time to close the position.