Bollinger Bands are standard deviation trendlines
overlayed above and below a stock’s moving average trendline. The default
settings of Bollinger Bands are normally two standard deviations above and
below the stock’s 20-day simple moving average. Approximately 95% of a
stock’s trading activity should fall within the upper and lower bands.
Below is a diagram of Bollinger Bands, using LMT as
the subject. LMT is an interesting company because the F-35 Joint Strike
Fighter program should supply a recurring revenue stream through the next
decade and possibly to 2040.
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Bollinger Bands are a statistical form of envelope.
Envelopes are trendlines that are plotted at a fixed percentage above and
below a stock’s moving average. By using the standard deviation versus a
fixed percent, the Bollinger Bands measure the volatility of a company’s
stock price. Volatility is reflected on a chart by the width (range) between
the bands that constantly change. The bands widen when there are large price
swings and narrow as the price swings stabilize and the price becomes more
Bollinger Bands are a good visual guide, indicating
whether a stock is selling at the top or bottom end of its price range.
The consensus, however, is that the bands by
themselves do not generate buy or sell signals, but need to be confirmed
with other indicators. The Relative Strength Indicator (“RSI”) is often
suggested as a confirming indicator, mainly because its underlying basis is
different from that of the Bollinger Bands. RSI is based on a comparison of
a stock’s up-days versus down-days, while the Bollinger Bands are based on
a stock’s volatility. That said, there is a high probability that when the
stock price tags the upper or lower band, the price trend may reverse.
Price movements that start at one end of a band
normally continue to the other end. This is also a good way to project a
target price for a security.
When the width of the bands contract to a narrow
range, a sharp price movement often follows.
When the stock price goes through the band, it is
usually considered a continuation of the current trend. If the stock price
does not reverse quickly, it indicates that the current trend is strong.
The number of standard deviations will depend on the
required length of the moving average, as well as the degree of certainty
that the investor needs, to be ensured that stock prices will fall within
the upper and lower range of the bands. A short time frame 10-day (period)
moving average requires a 1.5 standard deviation, while a longer 50-day
(period) requires a 2.5 standard deviation.
development of Bollinger Bands was a creative way to use business statistics
to help investors make profitable decisions in the stock market.