After years of active trading and investing, we have determined that a single technical indicator stands head and shoulders above the rest.
This indicator is not a chart pattern or other nebulous, difficult to understand and utilize concept.
It is a simple idea based upon the most widely used technical indicator or all time, the moving average.
First, let’s take a look at the problem most investors have with technical indicators
There is a huge controversy among traders and investors. The online investing message boards are full of flame wars about this very subject. Most investors are truly stuck in their ways and will defend their belief to the end when it comes to this controversy.
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Even investors who are constantly losing money often stick to their guns when it comes to supporting their opinion in this regard.
Believe it or not, it is technical analysis indicators that cause such strong beliefs among traders and investors. They often act like mad babies whenever their favorite indicator is challenged.
Most everyone has their own favorite indicator and strongly believe that it is the holy grail to success. The funny part is that it really doesn’t seem to matter how effective the indicator actually is in the real market. As long as it looks like it works on the past price chart, traders will defend its effectiveness to the death!
Often this is the death of their account, as most every technical indicator looks great in hindsight on the price chart, but in real time they fall flat on their face.
This unfortunate situation is due to something that psychologists call hindsight bias. Hindsight bias is the tendency to project the past into the future to your detriment. It is officially defined as:
The knew-it-all-along effect or creeping determinism, is the inclination, after an event has occurred, to see the event as having been predictable, despite there having been little or no objective basis for predicting it.
Hindsight bias is very prevalent among all investors, but it is a particular nuisance among active traders. It is critical that market participants see beyond hindsight bias when evaluating technical indicators.
We have determined that a single technical indicator is far superior to the others. This indicator is based on the tried and true moving average concept.
Based on the best of my knowledge, the 200 day simple moving average is the primary technical indicator used by large institutions and hedge funds. This alone is a powerful endorsement of the moving average indicator.
The indicator I am referencing uses a moving average then two other moving averages set a deviation above and below the middle moving average.
My research and hands on trading have proven the value of this concept many times over. While no technical indicator is fool proof when it comes forecasting the future. This particular tool can be uncannily accurate many times.
The best part is that this technical tool is built into most every trading platform and charting software. It is found for free on sites like stockcharts.com, and there is a tremendous amount of tutorial on this tool all over the internet.
In case you haven’t guessed it, I am referencing Bollinger Bands.
Bollinger Bands allow you to combine the benefits of both discretionary and quantitative trading into a unified whole. While they are not as accurate as real quantitative trading, and not as flexible as pure discretionary trading, Bollinger Bands provide the critical aspects of each in a simple to use format.
Let’s take a closer look:
Bollinger Bands are my favorite technical indicators. Over my investing career, I have found Bollinger Bands to be the perfect tool to quantify visually price moves. The best part is the fact that Bollinger Bands are extraordinarily simple to benefit from and very efficient for profiting from price changes
Bollinger Bands are moving averages that wrap around price bars on a stock chart. You are most likely familiar with moving averages. A moving average is a mean or average price of a series of prices. It is posted on the chart as a line with 20 period, 50 period, and 200 period being the most commonly used. The period can be anything from seconds up to months depending on the time frame that you are trading.
Bollinger Bands are made up of three moving averages. The middle band is the standard moving average, and the other two are set several deviations above and below the central simple moving average.
The bands got their name from their popularizer John Bollinger. He is credited with developing a statistically based standard for the bands, building trading concepts around them, and popularizing their use.
Standard Bollinger Bands consist of a 20 period Moving Average, an upper band two deviations above the MA, and a lower band two deviations below the MA.
Here is the formula for those of you who prefer to program the bands rather than look at charts.
How To Use Bollinger Bands
The purpose of Bollinger Bands is to determine visually if the price is high or low on a relative basis.
This means high or low as price relates to the average, which is the middle line or 20 period MA on the stock graph.
The further away the upper band moves from the center, the more likely price is to revert to the middle or mean.
If the price bar pushes or breaks through the upper or lower band, traders will place a trade in the opposite direction with the anticipation that price will soon revert to the mean ( the middle line),
It is important to keep in mind that this doesn’t always work as expected. Price can travel along the upper or lower band for a long time prior to reverting to back to the average.
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 top 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.
Slim Jims and Fat Boys
I call my favorite Bollinger Band patterns Slim Jim and Fat Boy. These are Bollinger Band patterns that are highly accurate in projecting what will happen next with price. Let’s first take a look at Slim Jims.
Slim Jims are also known as Bollinger Band Squeezes. What you want to watch for is narrowing Bollinger Bands. Most textbooks teach to look for Bollinger Band widths that are at the low end of their six-month range. You don’t have to rely on just looking at the bands. There is an indicator called Bollinger Bandwidth that can be used as a screener to find Slim Jims.
Fat Boys are the opposite of Slim Jims. Fat Boys occur when the Bollinger Bands expand to a relative wide level. This expansion indicates surging volatility. When you notice the Bollinger Bands expanding into Fat Boys this means that the market is trending in the direction of the expansion. This expansion confirms the trend. As the market trends though, any deceleration in momentum will cause the Bollinger Band which was headed away from the price trend to turn back to the same direction of the price trend.
It’s important to remember that the bands are better used as a technical analysis of stocks divergence confirmation indicator rather than a standalone trading tool.