In "Trading BofA Using Moving Averages," I discussed how moving-average technical analysis can pinpoint short-term trading opportunities even in a beaten-up stock such as Bank of America (BAC).
In this article, I will introduce Bollinger bands, a more-sophisticated technical analysis tool based on the moving average. Bollinger bands can show when the stock price is ready to break out, either sharply upward or downward, or whether the price is lazily churning without any clear movement either up or down. Then, I summarize the results of my research in my Tech Stock Bollinger Band Analysis, January, 2009 portfolio on Stockpickr, which extends the Bollinger band analysis to other popular tech sector stocks, such as Google (GOOG), Apple (AAPL), Dell (DELL), Research In Motion (RIMM) and IBM (IBM).
Is Microsoft in a Serious Downtrend?
Microsoft (MSFT) recently announced, among other things, the layoff of 5,000 employees and 5,000 contractors, as well as flagging sales of Windows due to falling PC demand. In his video analysis of Microsoft’s chart, Dan Fitzpatrick used Bollinger bands, among other indicators, to see whether perhaps this news caused an overreaction in Microsoft’s stock price, creating a potential buying opportunity. He used terms such as “volatility squeeze” and “downside breakout," phrases that might be unfamiliar to many of you. I will try to clarify these terms.
Here’s a three-month candlestick chart of Microsoft, from Oct. 27, 2008, to Jan. 23, 2009, with its 20-day simple moving average as a green line and its 20-day, two-standard-deviation upper and lower Bollinger bands as red lines:
Yahoo! Finance
What should we make of this? Bollinger bands are based on the simple moving average of the stock (the green line). Since 20 days comprise about a month of trading, the 20-day SMA is commonly used. The high and low boundaries are then calculated using a mathematical measure of volatility called the standard deviation. Typically, two standard deviations are used, with the upper band two standard deviations above the SMA(20) and the lower band two standard deviations below it. Don’t worry about the actual formula. Your charting software will calculate and draw the bands automatically.
Bollinger bands show the stock’s volatility, an indicator of the strength of the price move. Wider bands confirm the strength of the move. From early November until about Dec. 15, Microsoft’s price was trending lower, and the Bollinger bands were relatively wide. Then, between Dec. 15 and Jan. 20, Microsoft’s price churned around a trading range, between 18 and 21. The bands narrowed, indicating less volatility. The lower volatility and lack of price movement is what’s referred to as a “volatility squeeze,” the area of the chart bounded by the red oval.
Then, suddenly, on Jan. 21, the Bollinger bands widened, on a sudden lower price movement. This action corresponded to Microsoft’s layoff news. To Fitzpatrick, this action signaled a “downside breakout” because of the combination of lower stock price action and higher volatility. Microsoft’s closing price of $17.20 on Jan. 23 was below the lower Bollinger band (17.52). This is a strong bearish signal and a reason to bail out quickly.
Is This Downtrend a Head Fake?
Let’s look at the trend over a year, from Jan. 25, 2008, through Jan. 23, 2009, with the same 20-day simple moving average and two-standard-deviation Bollinger band. Does the one-year chart confirm or negate the three-month chart?
Yahoo! Finance
Indeed, Microsoft’s stock price has, with a breathing spell from March 2008 to August 2008, been trending steadily downward for the year, as you can see from the volatility-squeeze time frame. The sharpest declines occurred when the Bollinger bands widened, the downside-breakout time frame. The latest downtrend does appear to be a continuation -- in fact, an even sharper version -- of this downward pattern. Purely from Bollinger-band analysis, this latest price drop does not look like a head fake.]
Can Bollinger Bands Predict Tech Stock Moves?
Charts are really great at predicting the past. Actually, they’re perfect, since hindsight is 20-20. The acid test is whether they can predict the future. If Bollinger bands can do that, they can lead us to large profits or prevent us from incurring large losses. I recorded the results in the http://www.stockpickr.com/members/port/Tech-Stock-Bollinger-Band-Analysi... target=”_blank”>Tech Stock Bollinger Band Analysis, January, 2009 portfolio on Stockpickr.
The results were inconclusive. I used a 1-month chart with the standard 20-day moving average -- two standard deviations band criteria. While Microsoft’s chart behaved more or less according to the rules, Google’s did not. In fact, Google declined precipitously, from Jan. 6, 2009 to Jan. 20, 2009, from 337 to 285, while its Bollinger band width stayed the same. After Jan. 20, however, its price shot up to 350 with band expansion, consistent with an upside breakout. Bollinger band analysis itself did not give a clear signal on when to either bail out of GOOG on January 6 or get back on board on Jan. 20. That’s just one example. Look at the other charts and you’ll discover a different pattern for each stock.
You should not rely on any one technical signal -- including Bollinger bands -- to make your buy or sell decision. Look for other signals that reinforce each other -- large volume with prices moving above or below your chosen moving average --that reinforce the trend.
Now It's Your Turn: How to Use Bollinger Bands
Your task: Find the exact time to buy or sell a stock based on its Bollinger bands.
Step 1: On Stockpickr, create a portfolio called “Day Trading Using Bollinger Bands: [Your Stockpickr Username]." (To create a portfolio on Stockpickr, you'll need to first log in. If you're currently not a Stockpickr member, you can register here.)
Step 2: Pick five stocks you are interested in buying or selling. Using your favorite charting software, such as Yahoo! Charts, plot the stock price and its Bollinger bands. Plot an intraday, or one-day, chart of your stocks, with intervals as small as one minute during the day.
Where is the stock trading relative to its Bollinger bands? Did the price break above or below them? Use the bands to pick the right time to buy or sell. Check out volume as well. A move on heavier than average volume makes the buy or sell signal even stronger. Document the times and prices for your trades in the "Reason for Picking" box.
Step 3: Repeat Step 2 for the next three trading days or until you feel comfortable trading real money. Are you honing your trading skills?
Remember: You should not rely on any one technical signal to make your buy or sell decision. Look for other signals, such as large volume with prices moving above or below your chosen moving average, that reinforce the trend.
Guess Who’s on Stockpickr Answers Today: David Peltier will be on Stockpickr Answers today (Friday, Jan. 30) to respond to questions posed by members of the Stockpickr community. Not a member? Join the Stockpickr community today -- for free.
