If you want to start trading stocks, there’s a lot to learn. One key tools when you start trading stocks is technical analysis. Technical analysis uses chart patterns to signal when to buy, sell or short a stock. Now, there are a lot of different indicators out there, but one of the most widely-used tool is Bollinger Bands. It’s simple to use and nearly all charting software offers this indicator. Let’s look at how to use Bollinger Bands to signal when to buy, sell or short a stock.
Start Trading Stocks Using Technical Analysis – Bollinger Bands
Bollinger Bands consist of three bands. The middle band is a moving average, and the upper and lower band are deviations from the moving average. The upper band is set by a certain number of standard deviations of the price. The same goes for the lower band. Therefore, this indicator takes into account volatility.
The whole idea behind the indicator is that if a stock’s price is above the upper or lower band, it indicates the stock price might “too high” or “too low.” In addition, the width of the band could be an indicator of volatility. If the bands are narrow, it indicates there’s less volatility. On the other hand, when the bands are wide, it means the stock experienced higher volatility.
Generally, traders like to use the 20-period moving average for the middle band. Thereafter, they may set the standard deviations to 2. Therefore, the upper band would be 2 standard deviations above the 20-period moving average. Additionally, the lower band would be 2 standard deviations below the moving average.
Now, let’s look at some examples to give you a better idea of how to start trading stocks using technical analysis.
Start Trading Stocks – Bollinger Bands Examples
Check out the daily chart on Michael Kors Holdings Ltd. (KORS).
Now, we set the Bollinger Bands to 20 and 2. That means we used a 20-day simple moving average (SMA) and 2 standard deviations.
If you look at the chart above, you’ll see some horizontal lines. These could be used in conjunction with Bollinger Bands. Notice how KORS formed a top around $70, and the first time it broke above the upper band, it reversed the next day and found support around $67. After it broke the lower band, the stock rallied and approached resistance again and was above the upper band.
This would be a short signal. You could have shorted the stock around $69 and placed a stop above $70, which was the previous high. This pattern is known as a double top and is considered a bearish pattern. If you shorted the stock at those levels, you would’ve had some nice gains. Moreover, you could have covered your shares once the stock’s price broke below the lower band.
When a stock’s price breaks above the upper band, it signals a reversal is in the cards and the stock could fall. Conversely, if the price breaks below the lower band, it signals the stock could reverse and run higher.
Here’s a look at KORS again, but this time we’ll focus on looking at when to buy the stock.
You could also use bands to signal when to buy a stock. If you look at the chart above, you’ll notice KORS had some support just below $57. You could have used that level as a stop. Notice the encircled area. KORS broke below the lower band and you could’ve bought shares around $57.10 and stopped out if it broke below $56.50. The stock reversed after breaking the lower Bollinger Band and hit a $69 a few days after.
When you’re using Bollinger Bands, you should consider combining the tool with other indicators. For example, you might look at earnings, short interest, momentum and chart patterns.
You could start trading stocks using technical analysis once you’ve got a good grasp of some indicators. Bollinger Bands could be a powerful tool. However, you should use this indicator with other tools, such as support and resistance, trend lines or other technical patterns. Moreover, you might want to use technical analysis with catalyst events, which should increase the probability of success. Keep in mind that technical analysis is an art, and the stock could still continue higher or lower, even if it breaks above or below the upper or lower band, respectively.