Bollinger Bands® were created by John Bollinger in the 1980s and quickly became 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 highlight short-term price extremes of a security. The upper band represents overbought territory, while the lower band can tell you when a stock is oversold. Most technicians will use Bollinger Bands® in conjunction with other analysis tools to get a better idea of the current state of a market or security.
Most technicians will use Bollinger Bands® in conjunction with other indicators, but we wanted to look at a simple strategy that only uses the bands to make trading decisions. It has been found that buying the lower Bollinger Band® breakouts is a way to take advantage of oversold conditions. Usually, once a lower band has been breached due to heavy selling, the stock price will return above the lower band and move towards the middle band. This is exactly the scenario this strategy is trying to take advantage of. The strategy predicts a close below the lower band, which is then used as an immediate signal to buy the stock the next day.
Below is an example of how this strategy works under ideal conditions.
Figure 1 shows Intel crossing the lower Bollinger® band and closing below it on December 22. This clearly indicates that the stock was in oversold territory.
Our simple Bollinger Band® strategy calls for a close below the lower band followed by immediate buying the next day. The next trading day was not until December 26, when traders took their positions. It turned out to be a great exchange. December 26 marked the last time Intel traded below the lower band. As of today, Intel has exceeded the upper Bollinger® band. This is a classic example of what strategy is looking for.
Although the price action was not major, this example serves to highlight the conditions the strategy seeks to take advantage of.
Another example of a successful attempt using this strategy can be seen on the chart of the New York Stock Exchange when it crossed the lower Bollinger Band® on June 12, 2006.
NYX was clearly in oversold territory. Following this 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 rest of the month.
This is the ideal scenario that the strategy seeks to capture. In Figure 2, the selling pressure was extreme and, although the Bollinger Bands® adjust for this, June 12 marked the largest sell-off. Opening a position on June 13 allowed traders to enter just before the reversal.
In another example, Yahoo broke the lower band on December 20, 2006. The strategy called for an immediate purchase of the stock on the following trading day.
Just like the previous example, there was still selling pressure on the stock. While everyone was selling, the strategy calls for buying. The breakout of the lower Bollinger Band® signaled an oversold condition. This proved correct, as Yahoo quickly reversed course. On December 26, Yahoo retested the lower band, but did not close below it. This would be the last time Yahoo tested the lower band as it progressed to the upper band.
Ride the group down
As we all know, every strategy has its drawbacks and this one is certainly no exception. In the following examples, we will demonstrate the limitations of this strategy and what can happen when things don't go as planned.
When the strategy is incorrect, the bands are always broken and you will find that the price continues to fall as it moves up the band downwards. Unfortunately, the price does not rebound as quickly, which can lead to significant losses. Over the long term, the strategy is often correct, but most traders will not be able to withstand the declines that may occur before the correction.
For example, IBM closed below the lower Bollinger Band® on February 26, 2007. Selling pressure was clearly in oversold territory. The strategy called for a purchase of the stock on the following trading day. As in the previous examples, the following trading day was a bear day; this one was a bit unusual in that the selling pressure caused the stock to fall sharply. The selling continued well after the day the stock was purchased and the stock continued to close below the lower band over the next four trading days. Finally, on March 5, the selling pressure ended and the stock turned around and moved back toward the midband. Unfortunately, by then the damage was done.
In another example, Apple closed below the lower Bollinger® Bands on December 21, 2006.
The strategy provides for the purchase of Apple shares on December 22. The next day, the stock moved downward. Selling pressure continued to push the stock lower, where it hit an intraday low of $76.77 (over 6% below the entry) just two days after entering the position. Eventually, the oversold condition was corrected on December 27, but for most traders who could not withstand a short-term decline of 6% in two days, this correction was not of much help. comfort. This is a case where sales continued despite a clearly oversold territory. During the sale, there was no way of knowing when it would end.
What we learned
The strategy was correct in using the lower Bollinger® Band to highlight oversold market conditions. These conditions were quickly corrected as stocks moved back towards the intermediate Bollinger Band®.
However, there are times when the strategy is correct, but the selling pressure persists. Under these conditions, there is no way of knowing when the selling pressure will end. Protection must therefore be put in place once the purchasing decision has been made. In the NYX example, the stock climbed undeterred after closing below the lower Bollinger Band® for a second time. The strategy correctly led us to launch into this business.
Apple and IBM were different because they did not break through the lower band or rebound. Instead, they succumbed to increased selling pressure and pushed the lower band lower. This can often be very costly. Ultimately, Apple and IBM recovered, proving the strategy was the right one. The best strategy to protect ourselves from a trade that will continue to push the band lower is to use stop-loss orders. In researching these trades, it became clear that a five-point stop would have gotten you out of the bad trades, but still wouldn't have gotten you out of the ones that worked.
Buying at the breakout of the lower Bollinger Band® is a simple strategy that often works. In all scenarios, the breakout of the lower band occurred in oversold territory. The timing of transactions seems to be the biggest problem. Stocks that cross the lower Bollinger® band and enter oversold territory face strong selling pressure. This selling pressure is usually corrected quickly. When this pressure was not corrected, stocks continued to make new lows and remain in oversold territory. To use this strategy effectively, a good exit strategy is necessary. Stop-loss orders are the best way to protect yourself against a stock that will continue to move down the lower band and reach new lows.