John Devcic,
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market
Bollinger bands were created by John Bollinger in the '80s, and they have quickly become one of the most commonly used tools in technical analysis. Bollinger bands consist of three bands - an upper, middle and lower band - that are used to spotlight extreme short-term prices in a security. The upper band represents overbought territory, while the lower band can show you when a security is oversold. Most technicians will use Bollinger bands in conjunction with other analysis tools to get a better picture of the current state of a market or security. (To learn more about how Bollinger bands are constructed see, The Basics of Bollinger Bands.)
The Strategy
Most technicians will use Bollinger bands in conjunction with other indicators, but we wanted to take a look at a simple strategy that uses only the bands to make trading decisions. It has been found that buying the breaks of the lower Bollinger band is a way to take advantage of oversold conditions. Usually, once a lower band has been broken due to heavy selling, the price of the stock will revert back above the lower band and head toward the middle band. This is the exact scenario this strategy attempts to profit from. The strategy calls for a close below the lower band, which is then used as an immediate signal to buy the stock the next day.
Example 1: Intel Corp. (INTC)
Below is an example of how this strategy works under ideal conditions.
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| Figure 1 |
| Chart by StockCharts.com |
Figure 1 shows that Intel breaks the lower Bollinger band and closes below it on December 22. This presented a clear signal that the stock was in oversold territory.
Our simple Bollinger band strategy calls for a close below the lower band followed by an immediate buy the next day. The next trading day was not until December 26, which is the time when traders would enter their positions. This turned out to be an excellent trade. December 26 marked the last time Intel would trade below the lower band. From that day forward, Intel soared all the way past the upper Bollinger band. This is a textbook example of what the strategy is looking for.
While the price move was not major, this example serves to highlight the conditions that the strategy is looking to profit from. (For related reading, see Profiting From The Squeeze.)
Example 2:
Another example of a successful attempt using this strategy is found on the chart of the New York Stock Exchange when it broke the lower Bollinger band on June 12, 2006.
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| Figure 2 |
| Chart by StockCharts.com |
NYX was clearly in oversold territory. Following the strategy, technical traders would enter their buy orders for NYX on June 13. NYX closed below the lower Bollinger band for the second day, which may have caused some concern among market participants, but this would be the last time it closed below the lower band for the remainder of the month.
This is the ideal scenario that the strategy is looking to capture. In Figure 2, the selling pressure was extreme and while the Bollinger bands adjust for this, June 12 marked the heaviest selling. Opening a position on June 13 allowed traders to enter right before the turnaround.
Example 3: Yahoo Inc. (YHOO)
In a different example, Yahoo broke the lower band on December 20, 2006. The strategy called for an immediate buy of the stock the next trading day.
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| Figure 3 |
| Chart by StockCharts.com |
Just like in the previous example, there was still selling pressure on the stock. While everyone else was selling, the strategy calls for a buy. The break of the lower Bollinger band signaled an oversold condition. That proved correct, as Yahoo soon turned around. On December 26, Yahoo again tested the lower band, but did not close below it. This would be the last time that Yahoo tested the lower band as it marched upward toward the upper band.
Riding the Band Downward
As we all know, every strategy has its drawbacks and this one is definitely no exception. In the following examples, we'll demonstrate the limitations of this strategy and what can happen when things do not work out as planned.
When the strategy is incorrect, the bands are still broken and you'll find that the price continues its decline as it rides the band downward. Unfortunately, the price does not rebound as quickly, which can result in significant losses. In the long run, the strategy is often correct, but most traders will not be able to withstand the declines that can occur before the correction.
Example 4: International Business Machines (IBM)
For example, IBM closed below the lower Bollinger band on February 26, 2007. The selling pressure was clearly in oversold territory. The strategy called for a buy on the stock the next trading day. Like the previous examples, the next trading day was a down day; this one was a bit unusual in that the selling pressure caused the stock to go down heavily. The selling continued well past the day the stock was purchased and the stock continued to close below the lower band for the next four trading days. Finally, on March 5, the selling pressure was over and the stock turned around and headed back toward the middle band. Unfortunately, by this time the damage was done.
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| Figure 4 |
| Chart by StockCharts.com |
Example 5: Apple Computer Inc. (AAPL)
In a different example, Apple closed below the lower Bollinger bands on December 21,2006.
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| Figure 5 |
| Chart by StockCharts.com |
The strategy calls for buying Apple shares on December 22. The next day, the stock made a move to the downside. The selling pressure continued to take the stock down where it hit an intraday low of $76.77 (more than 6% below the entry) after only two days from when the position was entered. Finally, the oversold condition was corrected on December 27, but for most traders who were unable to withstand a short-term drawdown of 6% in two days, this correction was of little comfort. This is case where the selling continued in the face of clear oversold territory. During the selloff there was no way to know when it would end.
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What We Learned
The strategy was correct in using the lower Bollinger band to highlight oversold market conditions. These conditions were quickly corrected as the stocks headed back toward the middle Bollinger band.
There are times, however, when the strategy is correct, but the selling pressure continues. During these conditions, there is no way of knowing when the selling pressure will end. Therefore, a protection needs to be in place once the decision to buy has been made. In the NYX example, the stock climbed undaunted after it closed below the lower Bollinger band a second time. The strategy correctly got us into that trade.
Both Apple and IBM were different because they did not break the lower band and rebound. Instead, they succumbed to further selling pressure and rode the lower band down. This can often be very costly. In the end, both Apple and IBM did turn around and this proved that the strategy is correct. The best strategy to protect us from a trade that will continue to ride the band lower is to use stop-loss orders. In researching these trades, it has become clear that a five-point stop would have gotten you out of the bad trades but would have still not gotten you out of the ones that worked. (To learn more, see The Stop-Loss Order - Make Sure You Use It.)
Summary
Buying on the break of the lower Bollinger band is a simple strategy that often works. In every scenario, the break of the lower band was in oversold territory. The timing of the trades seems to be the biggest issue. Stocks that break the lower Bollinger band and enter oversold territory face heavy selling pressure. This selling pressure is usually corrected quickly. When this pressure is not corrected, the stocks continued to make new lows and continue into oversold territory. To effectively use this strategy, a good exit strategy is in order. Stop-loss orders are the best way to protect you from a stock that will continue to ride the lower band down and make new lows.
By John Devcic,
Access Investopedia's Forex Advisor FREE Report - The 5 Things That Move The Currency Market
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