Friday, December 28, 2007

Screening to Win: Bollinger Bands

The overview below describes one of the common technical indicators – Bollinger Bands and provides insights on how to utilize it in your stock selection. Hopefully this outline will provide traditional fundamental investors with some solid insight on how to incorporate technical indicators into their screening. The free HingeFire Stock Screener which can be found at is one of the few tools available that includes a wide selection of fundamental and technical criteria for selecting stocks. Using a combination of fundamental and technical screening is a powerful tool for winning in the market.

Bollinger Bands

Bollinger Bands Overview

Bollinger Bands were created by John Bollinger in the early 1980s. The intention of Bollinger Bands is to allow the dynamic comparison of volatility and associated price levels over time.

Bollinger Bands are created by taking a 20 day SMA average and then placing two bands, one above and the other below, at two standard deviations away from the central SMA line. These bands are drawn on the same chart as the stock price.

The lower Bollinger band normally marks a support level while the upper band defines resistance. Many times a dropping or rising price level only crosses outside the bands for a single day. In some sense most stocks are not more volatile than the bands associated with Bollinger, any price outside the band is likely to quickly revert to a level inside. One exception are situations in which the equity price is quickly rising and falling, and the bands “open up” as the volatility increases.

The HingeFire tool provides support to incorporate Bollinger Bands in your creation of screens for stocks. Users can scan to find stocks whose prices are at extreme and unsustainable short-term levels. The HingeFire screener can uncover stocks that are outside the upper and lower Bollinger Bands, as well as those where the price has just crossed these levels in either direction.

How to use Bollinger in screening

Most investors utilize the crossovers above the upper Bollinger Band or below the lower Bollinger Band when screening with the indicator. Bollinger crossovers represent volatility extremes, and usually imply that the price will snap back shortly. Many times these serve as excellent short-term entry points when confirmed with other indicators.

Another common method to screen with Bollinger is to scan for stocks that are outside the upper and lower bands. This will catch stocks that have been in these extremes for more than a single day.

Crossing above the upper Bollinger

The upper Bollinger Band serves as a resistance level. Stocks whose prices rise above this level tend to snap back below it, many times in under a single day. This is especially true in situations where the bands do not “open up” due to increased volatility. If the Bollinger Bands remain steady in width then if is likely that the price increase above the upper band is short lived.

AANB (Abigail Adams National Bancorp Inc.) crossed above the upper Bollinger Band. Note that the bands are not widening, but have remained fairly static in width over time. It is likely that this price rise outside the upper band over the $11.62 level will not last. The normal expectation will be for the closing price to drop below the band shortly. To many investors this would serve as an indicator that they should wait before entering long, and only consider a short-term short position as the current price levels.

Crossing below the lower Bollinger

The lower Bollinger Band acts as a support level. Normally when the price of a stock falls below the lower band, it tends to revert back above it. The cross below is of interest because this event many times lasts only a single day and serves as a good long entry point in some situations.

GWR (Genesee & Wyoming Inc.) dropped below the lower Bollinger Band today when the price closed at $24.78. The width of the bands has not changed greatly over the past couple of months after widening after the drop in November. The current drop started in early December starting near the upper band and now possibly ending after crossing the lower band. Assuming the information cross correlates with other technical and fundamental indicators, this may serve as a good entry point for a long investor.

Price above upper Bollinger

Sometimes the price can rise above the upper Bollinger Band for several days before retreating to inside the band. This usually occurs in scenarios where the band rises and widens with the increase in the stock price and volatility.

EEQ (Enbridge Energy Management LLC) rose outside the upper Bollinger Band for several days in early November. The closing prices remained outside the band for five days as the stock price rose and the Bollinger Band widened. Eventually the stock price peaked and reverted below band. Some investors screen for situations where the stock price is above the upper Bollinger Band, pull up the charts, and then implement short trade entries after the price action peaks out.

Price below lower Bollinger

In some situations, the price of a stock can drop below the lower Bollinger Band for several days. This usually occurs in scenarios where the stock price is in free-fall and the band widens to accommodate the increasing volatility. Normally the price will revert inside the band after a few days when the selling momentum dissipates.

A recent scan using the HingeFire tool found that WYE (Wyeth) dropped below its lower Bollinger Band for the past three days. The band has opened up in the direction of the price drop and widened. As with many situations, the recent drop in Wyeth is a news driven event, the market has concerns about potential generic competition with one of it leading patent-protected drugs. Usually these types of news stories only hold the price down for a short period of time. A patient investor would monitor this situation and wait for an opportunity to put on a long position if they believe the fundamentals of the company are sound.

Bollinger Summary

By themselves, Bollinger Bands do not normally generate pristine buy and sell signals. It is best to cross correlate information from Bollinger with other technical indicators before taking action. On a chart, Bollinger Bands are excellent for identifying periods of high and low volatility, as well as extreme pricing levels.

Many investors utilize Bollinger to look for divergences in stock price and the volatility of the bands. A small number of investors try to set different Bollinger periods and standard deviations on charts to match the particular equity under evaluation. However the traditional 20 day Bollinger with two standard deviation bands is normally the best for intermediate term studies.

The HingeFire tool supports users in screening for the following situations with the Bollinger Band indicator:

  • Crossing above the upper Bollinger.
  • Crossing below the lower Bollinger.
  • Price above the upper Bollinger.
  • Price below the lower Bollinger.

Combining technical indicators such as Bollinger Bands with commonly used fundamental criteria and technical indicators when selecting your investments helps put the market edge in your corner. The Bollinger support in the HingeFire Stock Screener adds a powerful tool that enables the searching for volatility-related extremes which will improve the timing of your market transactions.