USING BOLLINGER BANDS TO SPOT SUPPORT AND RESISTANCE LEVELS -- %B CAN ALSO BE USED TO SPOT OVERBOUGHT AND OVERSOLD CONDITIONS -- CURRENT READINGS SHOW THE MARKET TO BE IN AN UPTREND BUT OVEREXTENDED
BAND SUPPORT AND RESISTANCE LEVELS... I recently applied Bollinger bands to one of the major stock indexes to show the current uptrend and, more importantly, to spot any downturn. I thought this would be a good time to explain this useful indicator more fully, and to show different ways that it can be utilized. [The bands are named for John Bollinger who developed them]. Chart 1 applies the bands to the Nasdaq Composite. The middle dotted line is the 20-day moving average. The two outer bands are placed two standard deviations above and below the middle line. Statistically, 96% of the price action normally takes place between the two outer bands. As a result, the outer bands usually act as support and resistance levels. That's especially true during a sideways period like between June and August (see arrows). A short-term uptrend is signaled when prices cross above the middle 20-day line as last happened in early September (see circle). During an uptrend, prices fluctuate between the upper band and the middle line. In other words, the 20-day average is the first line of defense on any pullbacks. If and when the 20-day line is broken, prices will usually drop to the lower band where more substantial support is likely. The actual values of the three lines are in the upper left of the chart. The bands can also be used to spot overbought and oversold levels.
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Chart 1
BAND OVERBOUGHT AND OVERSOLD LEVELS ... Chart 2 shows how to use Bollinger bands to spot overbought and oversold levels. Also developed by Bollinger, the upper black line in Chart 2 called %B quantifies where a market is relative to the outer bands and the 20-day line. Basically, %B places Bollinger bands in an oscillator format. The middle level (.50) is the equivalent of the 20-day average. A reading of 1.00 puts the price at the upper band (resistance), while a reading of 0.00 puts the price at the lower band (support). A.%B crossing over .50 coincides with the price crossing over the 20-day line and constitutes a short-term buy signal (see circles). The short-term uptrend remains intact as long as the %B remains above the 0.50 line. The main reason for viewing %B is to determine an overbought or oversold condition. As in most oscillators, %B also helps us to spot positive or negative divergences. Chart 2 shows %B still in an uptrend (over.50), but in overbought territory (having recently exceeded 1.00). %B also shows a minor negative divergence from the previous peak hit in early September (down arrows), which suggests that the Nasdaq is stretched too far to the upside. For an actual short-term sell to be triggered, however, the index would have to fall below the .50 level (or 20-day average). If that were to occur, another important buying opportunity would take place near its lower band (near 2350) which would coincide with an oversold %B territory near 0.00. Daily Bollinger band (and %B) signals can be filtered with weekly signals as well.
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Chart 2
USING WEEKLY BANDS ... "Weekly" Bollinger bands measure the market's longer trend, and can be used as a filter on daily signals (which is the case with most technical indicators). In other words, weekly bands help determine which side of the market to be trading from. In addition, weekly %B helps determine intermediate overbought or oversold levels. Weekly Bollinger bands use 20 weeks as the middle line (20 is the default middle value for any time dimension). In Chart 3, however, I've converted "weekly" bands into "daily" bands by using 100 trading days (20 times 5). That enables me to use weekly bands on a daily chart. I'm just doing that here for comparison purposes. [In most cases, I switch from daily to weekly to monthly using 20 as the middle value]. The purpose of using weekly bands is twofold. The first is to determine which side of the market to be trading from. Since prices remain above the middle line (100 day avg. or .50), the longer trend is up which favors a strategy of buying any short-term dips. Weekly %B, however, is above 1.00 which puts the Nasdaq in the most overbought level since early April. That's an additional warning sign that the Nasdaq is stretched too far on the upside (as is the fact that it's right up against its April high). [Monthly bands (not shown) have been in a long-term uptrend since last summer]. Here's how I would combine the three trends. Monthly and weekly bands point upward and favor a strategy of buying dips. Weekly and daily %B lines, however, tell us the Nasdaq (and most other stock indexes) are in overbought territory. In that case, I'd utilize daily signals to determine where to took for support on pullbacks. That would be either at the 20-day average or the lower Bollinger band shown by the blue arrows in Chart 2.
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Chart 3
POTENTIAL SUPPORT LEVELS... Charts 4 and 5 show where potential support levels are located on any downside correction for the Dow and the S&P 500. Both indexes are threatening initial support at their 20-day averages (dotted line). Any decisive close below the 20-day average would turn the market's "short-term" trend lower. [That odds of that happening are increased by the MACD lines (above charts) turning negative for the first time in two months]. If and when the 20-day line is broken, a drop to the lower bands (blue arrows) would become more likely. [Those lower levels are currently 10820 for the Dow and 1144 for the S&P 500]. Interestingly, the lower bands aren't that far from 50-day averages (red lines) and chart support long the August highs. That's where I'd be looking to consider additional stock purchases on any downside correction. While short-term traders can use any break of the 20-day line as an excuse to take some profits, longer-term investors can use the lower band as a place to do more buying. Or, as an alternative, you can let any downside correction run its course and wait for the daily stock prices to cross back above the 20-day line before initiating new purchases. Either way, Bollinger bands can be very helpful in timing purchase and exit points.
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Chart 4
