Using Bollinger Bands for Trading Large Cap Stocks

The Bollinger Band is the closest thing to ‘The Holy Grail’ of
technical analysis there is. Especially for large cap stock
traders, it just cannot be beat for analyzing charts. Having
said that however, there is probably no other technical
indicator misused or misunderstood as often as the Bolinger Band
(BB). This article is to provide the technical analyst with the
basics needed to interpret the many faces of the BB.

Before we begin, let me explain the type of trading done at
http://livingonlargecaps.blogspot.com. We trade large cap
stocks, we generally hold stocks for less than two months, and
make about 3-5% on an average trade. Done over and over again
throughout the year, we have made over 50% annual returns for
the last three years.

Now lets discuss what the Bollinger Band (BB) is. In its
standard usage, the BB is derived from taking the 20 day moving
average of the stock price. And then adding and subtracting two
standard deviations of that stock price and placing a line above
the moving average and below the moving average. Now without
having to re-visit my statistics classes of some 25 years ago, I
will try to clarify a standard deviation. It is simply a
measurement of how far the price has deviated above or below the
moving average. A stock going through a particularly volatile
patch, will see its BB’s expand, and a stock going through a
calm period, will see them contract.

BB’s are available on most charting software. Yahoo has them on
their technical analysis charts, as do most other web sites that
are dedicated to technical analysis. If you are unfamiliar with
them I urge you to right now, go experiment with them, using a
few stocks and market indicators like the Dow, or Nasdaq.

If you are familiar with technical analysis, and use indicators
such as the RSI or stochastic. You know one of the unique things
about the BB’s is they are placed right on the stock charts.
They are viewed in the context of the actual price movements. In
fact, for me, they define the stock chart. Stock charts tell me
way more about future movement with the BB placed on them. I
rarely do any analysis without them, except for perhaps an
initial viewing of a stock chart I am considering for watch list
placement. BB’s therefore do not give you a number, like most
other indicators, they don’t tell you an overbought or oversold
condition. They just provide a visual, a story, of where a stock
has been. Therefor you have to interpret.

But what can be learned is crucial, to guessing what will happen
next. BB’s can help you predict price movements, like no other
tool. The trick is, to know what to look for. In other articles
I will present what I require a price pattern to look like
before I even consider it. But for this article, realize that
price patterns need to be structured, calm, heading up, down or
flat. But they can’t be erratic. Erratic price patterns are
never worth trading..

If the upper band and the lower band are not moving in unison
then the pattern is erratic. There is one exception to this
rule, and that is at the beginning of a powerful up or down
move. Remember, the bands tell you where the price will fall in
relative to the 20 day moving average. Well, if a powerful move
is underway, then the price is moving away from the average, and
the bands expand. Once the bands expand it is too late to trade
that move, but the stock is worth watching, one can climb on
board on the next pull back.

But trading the way we do on our blog ,at
http://livingonlargecaps.blogspot.com, that has produced greater
than 50% return three years running, we like the bands to move
in unison. That shows predictability. And predictability is
crucial in getting large returns. It is not the home run we are
looking for, just hit after hit after hit. Load the bases
repeatedly and you generate runs. OK enough baseball analogy.
Here is an example, take the chart HIG. With BB’s in place look
at the chart in early June 2005. It is just after the powerful
upward move, that occurred in May. First notice in May how the
BBs expanded, as the stock shot straight up. Then in June the
bands moved in unison. Around mid June the stock touched its 20
day moving average, then its formation started to ‘bowl’ as it
moved up. Buy it here. Once it hits a 5% profit move up a
sliding stop, and ride the price up. Several things can be
learned form this chart. The single most bullish pattern, is a
stock that has small trading day ranges, and hugs the upper
band. It rides it up between the 20 day average, and the top
band. The bands are at an upward angle, that is not too steep.
And everything moves in unison, both bands, the moving average,
and most importantly for profits, the price.

If one should know anything about the stock market, it is this.
It is ruled by emotions. Emotions are like springs, they stretch
and contract, both for only so long. BB’s measure this like no
other indicator. A stock, especially widely traded large caps,
with all the fundamental research in the world already done,
will only lie dormant for so long, and then they will move. The
move after such dormant periods will almost always be in the
direction of the overall trend. If a stock is above it’s 200 day
moving average then it is in an uptrend, and the next move will
likely be up as well.

Look at the chart CIT, with the BBs of course. See how in June
2005, the BB’s contract late in the month. While the price
touches the lower BB. See how the stock is above the 200 day
moving average. And more importantly the slope of the 200 day
moving average is upward. The stock clearly wants to move up.
The bands are ridiculously close together. Buy right here, an
oversold stock, moving upward, with narrow bands. What happens
next is the bands expand, I call it fish lips, I love fish lips.
This stock could have been bought in June sold at exhaustion as
the bands had expanded with an upper band touch. And then
re-purchased in July and done again. While fish lips provide
remarkable entry signals, they generally aren’t held as long as
the upward unison movement of HIG mentioned above.

There you have the two most crucial lessons in Bollinger Bands.
The HIG pattern I call riding the wave, and the CIT pattern I
call fish lips. Riding the wave can usually be done longer up to
two months, using stops along the way, one doesn’t even really
need to watch it, of course one can as they ca-ching in one
those safe profits. The other pattern is fish lips, they are
usually held for less than a month, and are exited upon upper
band touches, or mare exactly retreats from upper band touches.
(When the price touches the upper band and then retreats). Fish
lips that re formed out of a flat pattern can often turn into
‘riding the wave,’ and then are held longer

Ct Larsen
http://www.articlesbase.com/finance-articles/using-bollinger-bands-for-trading-large-cap-stocks-1313.html