Entry and Exit Strategies: Make Informed Decisions with Bollinger Bands®

Views 12KMar 22, 2024

Bollinger Bands® serve as one of the most common tools in technical analysis. These market indicators can help track the progress of stocks and understand the current market conditions. When used with other technical analysis indicators, they can help you make informed decisions about your investments and develop a strategy to know the right time to buy or sell.

If you are new to technical analysis, you may wonder what Bollinger Bands® are. In this article, we will explore:

What are Bollinger Bands®
Patterns in Bollinger Bands®
How to read the signals provided by Bollinger Bands®
How to trade using Bollinger Bands® as buy and sell signals

If you haven't used Bollinger Bands® before, here is what you need to know.

What are Bollinger Bands®?

Bollinger Bands® were developed by John Bollinger in the 1980s to help track stock prices and volatility as a price envelope. The idea was that the charts would show which stocks were overbought or oversold and traders could analyze the bands to find and monitor trends in stock prices.

A set of Bollinger Bands® consists of three bands. The middle band represents the simple moving average, typically over a 20-day period. The upper band represents two times the standard deviation added to the value of the middle band. Meanwhile, the lower band takes the center band and then subtracts two times the daily standard deviation.

When you place all three bands on a single chart, it’s easier to see how the stock performs and the price fluctuates when compared to the upper and lower bands. Investors use these bands to determine the right investment entry and exit points. Because Bollinger Bands® only focus on the price and volatility and do not consider other factors, it is best to use these charts in addition to other investment tracking techniques to influence your investment decisions.

Patterns to look for with Bollinger Bands®

Since Bollinger Bands® help show how a security is falling or rising, as a trader, you may not always act when the prices touch either band or goes above or below (known as a breakout). Instead, you may want to wait for other chart patterns to develop like the double bottom, classic M top, and the three pushes high.

W Double Bottom Trend Reversal

A W double bottom happens when the price drops and spikes beneath the lower line, then recovers before hitting another low above the lower band but higher than the first low and not touching the band. The W double bottom often indicates a reversal in a bullish trend and may reflect that the price could be on an upward move.

Classic M Top

An M top happens when there is a price push to a high, then a sell-off reaction and price drop, followed by another price lift and high. If the first high touches or is outside the upper band, it typically reacts by dropping to the middle band, while the second high touches the inside of the upper band. The second high can be either higher or lower than the first high if it is still within the upper band and may represent a relatively low high. When a trader is watching the price trend up and down, it is hard to determine if it is on the upward trend or simply met resistance. However, the classic M top may signal a sell because of a bearish price movement.

Three Pushes to High

A three pushes to high pattern forms as the first push creates a high on the outside of the upper band, while the second makes a new high while touching the upper band, and the third push is within the upper band when it makes a new high, typically displaying a longer topping formation. Three pushes too high may indicate a decrease in momentum and volume.

How to calculate Bollinger Bands®

There is a standard formula for calculating the Bollinger Bands® that includes a number of variables:

BOLU = Upper Bollinger Band®

BOLD = Lower Bollinger Band®

MA = Moving Average

TP = Typical Price, or the (High Price + Low Price + Closing Price) / 3

n= number of days in a smoothing period

M = number of standard deviations

Σ[TP,n] = Standard deviation over last n periods of TP

Using these variables, you can then express the equation as:

How to read Bollinger Bands®

Now that we have explored how the Bollinger Bands® are calculated, we will explore what else these charts can show.

The bands themselves essentially create an investment sandwich. The moving average stays in the middle, with the upper and lower bands forming the bread. The distance between the upper and lower bands from the middle dictates how much the price has fluctuated.

It’s important to remember that Bollinger Bands® will always revert back towards the mean. When the bands are farther apart, that is a good indication that volatility has likewise increased and there may be a period of more stability in the future. On the other hand, if the bands move closer together, you know the volatility has decreased and there is a squeeze, with potential for explosive moves.

Similarly, you can see where the stock price falls within this investment sandwich. When the price approaches the upper band, investors may say that this indicates the stock has been overbought. Conversely, if the price approaches the lower band, the stock has been oversold.

Images provided are not current and any securities are shown for illustrative purposes only

The stock value in these charts can help inform your investments when used in conjunction with other strategies. You can gauge the stock's volatility, whether the stock has been oversold or overbought, and when you want to act.

How to trade using Bollinger Bands®

The signals provided by the Bollinger Bands® can help you make smarter decisions. Studying these charts can help highlight specific buy and sell signals as these charts assume that most closing prices should fall between the upper and lower band of the graph. Therefore, you can feel confident it will revert to its mean if the price goes outside the band. If the price falls below the Bollinger Band®, it may indicate an excellent buying time. Conversely, the stock was oversold if the price approached the lower band.

In a bearish trade

From the standpoint of a basic strategy, a price that hits the upper band line with a bearish trade will indicate the time for a short sale with a limited order. Investors can take their profits when the market hits the lower line.

If you want to join a breakout, you will want to go short when the price breaks out of the lower band. Conversely, you can also wait until the stock has a closing price below the lower Bollinger Band® before you make your move.

Finally, if you want to trade as a reversal trader, you want to find outliers that climb above the top Bollinger Band®. Then, you can take advantage of the apparent impending bearish reversal trade.

For bullish trades

On the other hand, your strategies may change slightly with a bullish trade. With a basic trade, you want to see the price of the stock fall to the lower band line. You can then purchase with a limited order. Ideally, you will want to exit when the market hits the upper band line.

You want a stop entry order or wait until the price bar closes above the line to join a breakout. Then look for an outlier bar below the Bollinger Band® to consider a bullish reversal setup.

If you want to join a breakout, it is best to look for it when the price breaks through the upper band line to use a stop order. Or, you can wait to see if the price crosses the line, which will make your investment a bit more conservative.

Finally, if you want to trade on the reversal, you will look for a stock price below the Bollinger Band®. You can then do a bullish reversal setup.

Use technical analysis to make investments on moomoo

Bollinger Bands® provide critical stock data to help traders make better decisions. The information they provide can help you gauge the volatility of a stock and whether it is likely to be overbought or oversold. Moomoo makes it easy to access data that can help you better understand the movement of stocks and investments to build the portfolio you want. The moomoo app offers free technical analysis tools with 63 indicators and 38 drawing tools.