Bollinger Bands are primarily used for mean-reversion trades. In other words, when a stock deviates from the norm, traders will look to either buy or sell it, expecting it to return back to the mean. Thus, traders can use Bollinger Bands as a signal to short a stock, when the price movement has risen significantly, typically more than two standard deviations from the moving average price.
Bollinger Bands Explained
John Bollinger — widely recognized for his contributions to the field of technical analysis — developed Bollinger Bands, an easy-to-use indicator that plots an upper band and lower band, which are generally two standard deviations from the moving average, or the mean. When prices deviate, this indicator could be a signal to either get long or short a stock for a mean-reversion trade.
Let’s focus here on the upper Bollinger Band for short-selling purposes. When the stock rises above the upper Bollinger Band, it generally pulls back to the moving average, and sometimes to the lower Bollinger Band. That said, it could uncover some short opportunities when this occurs.
Look at this example of using Bollinger Bands for short selling with the hourly chart on NVIDIA Corp. (NVDA).
In the chart above, you’ll notice three “bands” plotted. The red line is the 20-period simple moving average, while the upper band is the plot of two standard deviations above the 20-period simple moving average. The lower band is a plot of two standard deviations below the 20-period SMA.
If you were able to get short NVDA after it rose above its upper Bollinger Band, you would have had some profits.
The Bottom Line
Bollinger Bands can be used to signal a potential mean-reversion trade. That signal occurs when the price rises above the upper band, at which point you might consider shorting the stock and looking to take profits if/when it pulls back to the moving average. If you’re more risk tolerant, you could hold on until it reaches the lower Bollinger Band. Take note that Bollinger Bands are a technical indicator; these signals don’t work 100 percent of the time.
Davis Martin is the lead publisher at DailyProfitMachine.com. He trades SPY calls and puts and swing trades mid-large cap stocks and stock options.