It’s time for another installment of the series, Basic Technical Analysis for Dividend Investors. Last time, I introduced the subject of technical analysis and suggested that it should only be used as a secondary and supplemental tool after exhaustive fundamental analysis. This post will discuss one of my favorite technical indicators, Bollinger Bands.
Technical analysis is particularly useful for dividend investors when the decision to buy a stock has been made, but the purchase has not been executed yet. I also demonstrated one of the most basic technical tools that I use on a regular basis, the simple moving average (SMA). You can read the entire first installment by clicking here.
Here’s what Bollinger Bands look like using a six-month Emerson Electric (EMR) chart on Yahoo Finance:
The green line in the middle is the 20-day moving average. The upper and lower red lines are the Bollinger Bands. If your college statistics knowledge is a little rusty, you may want to pay attention while I quickly go over how the lines are derived. Or skip to what’s easier and more important, learning how to read the bands… a simple and intuitive skill that anyone can learn.
John Bollinger has been a familiar face in the financial industry for the past few decades. He’s a Charted Financial Analyst (CFA), Chartered Market Technician (CMT), financial TV network contributor, and heck, he’s got his own chart lines named after him… an impressive accomplishment by itself. Here’s the intro to Bollinger’s bands taken from his official website:
Bollinger Bands are a technical trading tool created by John Bollinger in the early 1980’s. They arose from the need for adaptive trading bands and the observation that volatility was dynamic, not static as was widely believed at the time. The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition, prices are high at the upper band and low at the lower band. This definition can aid in rigorous patter recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions. Bollinger Bands consist of a set of three curves drawn in relation to securities prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, that serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes.
In other words, to draw the Bollinger Bands, you take a simple moving average, and draw an upper and lower band using a standard deviation as a measure of volatility. Do you remember standard deviation from your statistics class? Let’s take a closer look.
Standard Deviation (This will be quick I promise)
Sorry to conjure up old nightmares from your high school and college statistics classes that everyone hated. If you want a refresher, Wikipedia has a good example of how to determine standard deviation and a simple graphic of the formula in the Basic Example section. The standard deviation, represented by the Greek letter Sigma (σ), is found:
by taking the square root of the average of the squared differences of the values from their average value.
You don’t really need to know or understand that, although seeing the math on Wikipedia is helpful. What is important, and something you may recall from class, is the 68–95–99.7 rule.
1 Standard Deviation (σ) = 68% of a distribution lies within 1 σ of the mean.
2 Standard Deviation (σ) = 95% of a distribution lies within 2 σ of the mean.
3 Standard Deviation (σ) = 99.7% of a distribution lies within 3 σ of the mean.
Graphically it looks like this:
The real-life example of standard deviation on Wikipedia is helpful, so I’ll include it here:
… the average height for adult men in the United States is about 70 inches, with a standard deviation of around 3 inches. This means that most men (about 68 percent, assuming a normal distribution) have a height within 3 inches of the mean (67–73 inches) – one standard deviation – and almost all men (about 95%) have a height within 6 inches of the mean (64–76 inches) – two standard deviations.
How Does This Translate Into A Stock Chart
Now that we’re through that painful memory of formulas and boring lectures, let’s go over how this applies to a basic stock chart. From the 20-day SMA, the standard deviation is calculated and the number is plotted on the stock chart above and below the stock price.
The lines represent a range that the stock price stays within 95% of the time, backward looking (we’re not looking into the future). In other words, using a standard deviation of two, 95% of the time the stock price does not go outside of the Bollinger Bands.
Here is a six month chart of Abbvie (ABBV) with the 20-day SMA in green and the Bollinger Bands set at two standard deviation. The percentage of time the stock price (represented by the blue line), is outside of the Bollinger Bands is 5%:
How To Use Bollinger Bands
Having the Bollinger Bands in your stock analysis tool belt is easier than you think. It’s a visual tool to help you make a determination of short-term price action and get a better price for a stock when you are buying. When the stock price hits or goes below the lower band, that means the stock is potentially oversold, because it has reached a relative point that happens only about 2.5% of the time (2.5% on the top, 2.5% on the bottom = 5%). That could mean in the short-term, it is a buying opportunity. The opposite is true on the top, when the stock price hits or surpasses the upper band, it could signal a selling opportunity. I’ll focus on the lower band from now on because most dividend investors aren’t trading out of stocks as frequently.
Since the Bollinger Bands are a measure of volatility, during times of more price volatility, the bands move further away from the SMA. During times of low volatility, the bands narrow to the SMA. A narrowing of the bands can signal that high volatility is coming soon. Volatility may show up in the form of a big spike up or down, where the price can hit or pass through the bands.
This next image is a closeup of the ABBV chart above. This time I’ve singled out the month of April. Back on April 11th, I snapped up some shares of ABBV because I saw a big dip in price when most biotechnology stocks were getting hammered. You can read about it in my April monthly update. When the stock clearly broke through the lower band, it was a buy signal.
In this example, it turned out to be an outstanding opportunity to buy. I picked up some shares at around $45.60, a price that the stock hasn’t seen since. A big part of getting that price was luck, being ready, and having the cash balance to buy on that particular day. But looking at the Bollinger Bands, the oversold indication was present to help me make that determination.
As with all stock analysis, a buy signal is not a guarantee. This next example below is taken from the EMR chart at the beginning of this post. I’ve zoomed in on the period in early August. Notice with increased volatility, the bands widen.
In this example, the Bollinger Bands indicate a buying opportunity at the first drop around $63.50 (top green arrow), only to find that the next day the price dipped below $62 (bottom green arrow). The market as a whole sold off in early August. While the Bollinger Bands indicated a buy at first, the broader market sell-off caused the stock to fall even further, indicating a second and better opportunity to buy the stock for less.
The lesson here is that like all other investment research tools, no technique or indicator is perfect.
How To Add Bollinger Bands To Your Charts
Adding Bollinger Bands to your chart on Yahoo Finance is easy. I prefer Yahoo Finance for all of my charting when using my desktop. On my mobile device I use my TD Ameritrade iPhone app. First get a quote of the company you are analyzing.
Then click on Interactive on the left hand side (you can also use Basic Tech. Analysis):
Next click the Technical Indicators drop down menu and choose Bollinger Bands:
That action will bring up parameters for you to input for your Bollinger Bands. The default values are 20 for the period (SMA) and 2 for the standard deviation. Intermediate users can play around further with the settings:
Click draw and… Voila! Your lines are drawn. You can also add a simple moving average equal to the period input to add get the baseline from which the bands are derived.
I hope you found this exercise useful and not too confusing. Bollinger Bands are yet another skill for dividend investors’ tool belts to help understand short-term price action when it’s time to buy a stock. In coming posts, I’ll be covering a few other indicators and overlays such as stochastics, and the relative strength index (RSI).
Do you use technical analysis when you buy stocks? What other tools and indicators do you use?