The concept of the Bollinger bands was introduced by John Bollinger in the '80s. It quickly became one of the most commonly used tools in market analysis. Bollinger approach employs three bands - an upper, a middle and a lower band that are used to highlight extreme short-term prices in a security. In our case we are talking about the price of a currency. However, the theory is applicable to the general stock market.
The upper band represents overbought area, while the lower band shows you when the currency is oversold. Many traders combine the Bollinger band techniques with other methods to get a better picture of the current state of a market. Consider a simple example that uses the Bollinger bands alone.
The theory is that buying the breaks of the lower Bollinger band is a way to take advantage of oversold conditions. Once the lower band has been broken due to heavy selling, the price will revert back above the lower band and head toward the middle band. This is a scenario this strategy assumes. Therefore, the Bollinger strategy closes below the lower band, which is then used as a signal to buy the stock the next day.
The figure above shows how Intel breaks the lower Bollinger band and closes below it on December 22. This presents a clear signal that the Intel stock was oversold. Now Our Bollinger strategy requires a close below the lower band followed by an immediate buy the next day. The next trading day is December 26 (see Figure above). Clearly, it is an excellent trade. December 26 marked the last time Intel would trade below the lower band. From that day forward, Intel climbs all the way until it reaches the upper Bollinger band. Sell and go to Bahamas for a martini! This is a textbook example of what the strategy is designed for.
We all know that no strategy is ideal. Each of them has its drawbacks and this one is definitely no exception. What happens when the Bollinger assumption does work? It is simple. The bands are still broken but the price continues its decline as it rides the band downward. The price does not rebound quickly and this may lead to a significant loss. In the long run, the strategy is often correct, but most traders are not be able to survive the long declines.
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