What are Bollinger Bands? This technical stock indicator was developed by John Bollinger in the 1980′s. It allows the user to compare the volatility of a stock and its relative price levels over a given period of time. This indicator is compiled from 3 bands, and can capture a vast majority of a stock’s price activity. Unlike a percentage calculation from a regular moving average, Bollinger Bands add or subtract 2 standard deviations from the moving average to create the upper and lower bands.
Bollinger bands are made up of:
1. A Simple Moving Average (SMA) in the middle
2. A lower band, which is the simple moving average (SMA) minus 2 standard deviations
3. An upper band, which is the SMA plus 2 standard deviations
When analyzing a stock with Bollinger bands, it is understood that when the price is above the SMA line and heading towards or above the upper band, it is thought to be overbought at that time, and that is a signal to sell or short the stock. Likewise, when the price of a stock is underneath the SMA line and heading towards or below the lower band, it is said that the stock is oversold and that it is a good time to buy.
Looking at the graph above of Bank of America (BAC), we see it trading at the lower end of the Bollinger bands and this would indicate a buy signal. However, looking back at the graph, we see that BAC has been trading at the lower end of the band for several consecutive months, which indicates a period of price discovery. Buying at any of these times would have incurred losses, so as always, it is best to combine technical indicators such as Bollinger bands with solid fundamental analysis.