​Technical Analysis: Bollinger Bands

There are twin brothers in the equity investment world.  One is the well-respected brother that has always succeeded when he puts his mind to things, and of course, his name is Chad.  He got into an Ivy League school because of a perfect GPA in high school. He wants to become a neurosurgeon and cure cancer.  Basically, this guy has a proven track record for success in this world; everyone knows that if Chad just stays on this path he’ll live the perfect life.  However, Chad’s twin brother is the complete opposite of him.  He stays out late partying; he’s extremely good looking (in a dark way) and gets all the girls.  He got into college, but he doesn’t really care too much about school He just wants to make as much money as possible as quickly as possible to fund his rock-star lifestyle.  Oh, and did I say his name is Jay?  Well, his name is Jay.  You might be saying, “This literally has nothing to do with finance,” and you’d be so wrong.

You would be wrong because, in the finance world, fundamental analysis is Chad.  Fundamental analysis has a trusted path and a proven track record for success when strictly followed.  This is the same way Chad’s path has quite an impressive track record.  On the other side of the coin, there’s Jay, who represents technical analysis.  In the finance world, technical analysis is not as well researched or respected as fundamental analysis.  It does not have as clear of a path to success as fundamental analysis. Basically, there are more billionaires to speak on behalf of fundamental analysis than technical analysis.  However, somebody like Jay doesn’t care about the research behind the method or the billionaires to speak of it. As long as it makes money as soon as possible he’s a happy camper.

To step away from the abused metaphor, there are a lot of people who have a made a good amount of money using technical analysis. It employs tools that are easy to use if you know what you are doing.  Personally, I believe technical analysis is best used in a combination with fundamental analysis. You can use fundamental analysis to pick the right stocks to buy and then use technical analysis to find price points of a good time to buy and sell.  On that note, let’s jump into our first tool to learn about!

Case #1: Bollinger Bands

Bollinger Bands were created in the 1980’s by a famous technical trader named John Bollinger.  Previous to John, one of the main tools used in technical analysis was a simple moving average.  A simple moving average (SMA) is simply (every pun intended) adding the closing price of a certain amount of days and dividing it by the number of days added.  Therefore, if we see a closing price over a 3 days period of 100, 108, and 110 then we are going to add all three prices up which equals 318 and then divide it by 3, or the number of days.  Therefore, our 3 days simple moving average equals 106.  We can do this over any period of time and get a moving average.  However, John did not think this was good enough and he took it a couple steps further than a simple moving average.

Bollinger Bands have a simple moving average in the middle of the tool and they are surrounded by a line at the top and a line at the bottom.  There are two things to figure out.  First, what do the line at the top and bottom tell us?  Second, how do I make money using this technique?  Luckily for both of us, I can answer these questions.

First, what the heck are these lines at the top and bottom?  The lines represent 2 standard deviations away from the simple moving average over a certain period of time.  The standard period for Bollinger Bands is 20 days and the most commonly used standard deviation is 2 in both directions.  In case you have not brushed up on your statistics lately, a standard deviation is the square root of the variance.  You might be saying, “That literally does not help me at all” and if that is the case then I apologize to you right now.  To find variance you subtract the mean from each observation in your data and then square each one to make them all positive.  After that is done, you must add up all of the squares and divide them by the number of observations.  However, the variance is not the standard tool used in finance or technical analysis.  We use standard deviation, and to find standard deviation we must take the square root of the variance we just found.  Standard deviation tells us how much our sample diverges from the mean.  Both variance and standard deviation are useful and tell us similar things, but the standard deviation is more intuitive to use because it is relative to our sample mean,  whereas variance is in squared terms.

What does it mean to have something that’s 2 standard deviations away?  Well, in statistics it is known that on a normal bell curve, data will fall within 1 standard deviation 68% of the time, 2 standard deviations 95% of the time, and 3 standard deviations 99% of the time.  Bollinger Bands use 2 standard deviations over a 20-day period which means that relative to the simple moving average, which is really the mean of the stock prices, we should expect the price to land within the upper and lower bounds of the Bollinger bands 95% of the time.  Pretty neat stuff right?  Look, don’t judge me because I enjoy this stuff.  Anyways, in recent studies, it has been found that because of the non-normal distributions of stock prices and the short periods that Bollinger Bands use, that we can expect stock prices to land within the bands around 88% of the time instead of 95%.

Just like anything in finance you need to learn how to make money from the stuff you learn because we’re savages (as I am sitting here with SpongeBob in the background).  Therefore, I am going to teach us the basics of how to use Bollinger Bands.  The intuition behind the technical tool is that prices will revert back to their mean, or the simple moving average that is in the middle of the of the upper and lower bound lines.  However, just like with any technical tool this is not something that should be used alone when making trading decisions. But it can give you a decent understanding of whether a stock is overbought or oversold.  When a stock breaks the upper bound, it generally means it is over-bought. This can be a good thing if it is trending upwards or a bad thing because it will have a tendency to revert back towards its mean.  When a stock breaks the lower-bound, it could mean that a stock is oversold or that it is simply trending downwards.  As you can see, each meaning would cause a trader to have a different reaction on whether they would buy or sell. That is why it is important to take a holistic approach when trading.  You cannot rely on one technical tool to make money because there are a million other people using the same tool. You must find your own combination to have a competitive advantage.

 

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