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Bollinger Bands and MACDs
As you gain investing knowledge and experience, you may come across Bollinger Bands and MACDs. They are technical trading tools that can help you get an idea of where the market is headed.
What are Bollinger Bands?
Bollinger Bands were introduced by John Bollinger, a well-known technical trader. They are used in technical analysis to depict the highs and lows in the price of a security over a defined timeframe. The bands represent positive and negative deviations from the SMA (Simple Moving Average) of a stock's price. They are composed of three lines or bands – the price line in the middle with one line above it and one below. By definition, price is high at the upper band and price is low at the lower band. Bollinger Bands can help you make informed decisions.
Bollinger Bands
o Upper band – 20-day SMA + 20-day standard deviation of price x 2
o Middle band – 20-day SMA
o Lower band – 20-day SMA – 20-day standard deviation of price x 2
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How do Bollinger Bands help traders?
Bollinger Bands are popular with traders for a number of reasons:
- User-friendly: Bollinger Bands can be read easily and are reactive to trading. As a trader, all you have to do is observe Bollinger Band positions over and under the SMA. Experienced traders study different Bollinger Band patterns for trading insight.
- Adjustable: Bollinger Bands are customizable. While they are usually positioned two set deviations away from the SMA, they can be adjusted as desired. You can change the bands to deviations that align with your trading style.
- Confirm trends: Bollinger Bands can help you confirm trends over a period of time.
How do you use Bollinger Bands for swing trading?
The goal of swing trading is to identify long term trends. Bollinger Bands are well-known technical indicators in the swing trading world. They help traders identify a probable turnaround in prices. To execute a basic swing trade, you could buy near the lower Bollinger Band and set limit orders to sell near the upper band. This strategy can be more profitable than the buy-and-hold method, especially for securities that move sideways. You can even tweak this strategy to lower your risk. All you have to do is adjust the Bollinger Band settings to a lower standard deviation.
Day Trading with Bollinger Bands
As reliable indicators of volatility, Bollinger Bands can help day traders as well. A simple day trading strategy could be to focus on two lines at a time – the middle price line and the upper one during an uptrend, and the middle price line and the lower one during a downtrend. This can help you identify signals as well as entry and exit points.
Once you have identified your entry and exit points you can set limit buy and sell orders within WebBroker that will be automatically executed at these price points.
You can learn more about limit orders here.
Are Bollinger Bands a lagging indicator?
Bollinger Bands are a lagging indicator and cannot be used to make price predictions. Their core function is to identify trends. This is because the tool is based on the SMA, which takes into account the average price over time.
The limitations of Bollinger Bands
- Simply reactive: Bollinger Bands cannot be used to predict prices. As they are based on a simple moving average, they can only react to upward movements or downtrends. This makes Bollinger Bands a lagging indicator.
- Standard settings aren't the best: The predefined settings may not work for every security or market. Traders then have to find settings that work for stocks that they are trading. If those settings fail, the only options are to alter the settings or switch to a different tool.
What is the MACD?
MACD stands for Moving Average Convergence/Divergence and is a popular technical trading data point. It is a momentum indicator that shows the relationship between two moving averages. It was developed in the late 70s by Gerald Appel and is still widely used in technical analysis.
Why do traders use the MACD?
The reason behind the popularity of the MACD is its histogram. Traders have come to rely on this indicator as a measure of momentum because it responds to the speed of price movement. It's safe to say that traders use the MACD to gauge the strength of a price move rather than to predict the direction of a trend.
Signal line crossovers, centerline crossovers, and positive and negative divergences can all be used to generate signals and spot changes in trend direction, strength, and momentum of a market.
Which timeframe is best for the MACD?
The MACD is flexible and can be customized to fit nearly any strategy. However, traders usually rely on the default settings of 12-day and 26-day periods. Over this timeframe, traders are looking for a positive MACD value. This is created when the short-term average is above the longer-term average and is used to signal increasing upward momentum. The MACD can also be used to signal increasing downward momentum. This can be valuable for individuals who are short selling the stock.
How do you spot divergence with the MACD?
Typically, the MACD is used to reveal whether a security is overbought or oversold. Once they have that information, traders can adopt strategies that account for a coming trend reversal. Traders using the MACD look for any signs of divergence. A divergence is triggered when the MACD forms highs or lows that deviate from the equivalent highs and lows on the price. A bullish divergence appears when the MACD forms two rising lows that correspond with two falling lows on the price. A well-known MACD trading strategy is known as trading divergences. When traders observe new highs in the security's price but not on the MACD, they know this indicates that momentum behind the higher prices is waning, and prices will soon adjust. At this point they either sell their long positions or enter short positions.
Is the MACD a lagging indicator?
As the data used in the MACD is based on the historical price action of the stock, it is a lagging indicator. However, a number of traders use MACD histograms to predict when a change in trend might occur.
What are the limitations of the MACD?
- False positive: While a divergence can often signal a possible reversal, there are times when no actual reversal takes place.
- Open to misinterpretation: If you don't have a firm grasp on the concept of moving averages, it's easy to misinterpret the results of the MACD.
How are Bollinger Bands & MACD used together?
While the MACD can help indicate the market's movement, Bollinger Bands highlight the sequential nature of the market. Traders use both MACD and Bollinger Bands to support deal arrangements.
Pros of Bollinger Bands and MACD
- Bollinger Bands and MACD are versatile and can be applied to any asset, across any timeframe
- Bollinger Bands naturally provide stop loss levels that coincide with the lower band for long trades and the upper band for short trades
- Both MACD and Bollinger Bands help traders quickly determine the trend and volatility of any market
Cons of Bollinger Bands and MACD
- It's not advisable for novice traders to combine Bollinger Bands and MACDs. If you're new to trading, you'll need to gain a comprehensive understanding of both systems.
- While Bollinger Bands work best in ranging markets, MACD is a trend following momentum indicator. Traders can receive mixed signals if Bollinger Bands and MACD are applied incorrectly.
How do traders use Bollinger Bands and MACD?
A little background knowledge can help traders use Bollinger Bands and MACD to identify successful trading strategies. Traders looking to trade Bollinger Band breakouts usually consider the following steps:
- Use MACD to identify a trending sector or market
- Look for any divergence in the MACD histograms which could signal a potential breakout
- Look out for a break of the 20 moving average or trendline
- Confirm if there is a breakout (breach of the bands), along with increased volatility (expanding bands) and increasing momentum (longer histograms)
If a security generally fluctuates over long periods within a set range, a rectangular pattern forms on the chart. At this point, Bollinger Bands can be used to set up profitable trades.
Why are Bollinger Band and MACD used together?
Bollinger Bands are effective indicators of volatility while MACD serves as a trend-following, momentum indicator. Together they assist in making higher probability trades by gauging the momentum of existing trends along with volatility. MACD can assess if a trend is picking up in momentum or slowing down and Bollinger Bands can be used as an entry or exit trigger and help in the confirmation of a trade.
On a final note
Bollinger Bands and MACD can help traders formulate successful trading strategies. However, due to their complex nature, they require a certain amount of knowledge and and investing discipline. You can leverage real-time streaming market data, analytical tools, and advanced trading capabilities to spot trends and potential trading opportunities with Advanced Dashboard from TD Direct Investing.
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