By Hemanth Gorur
Fundamental analysis of stocks helps long-term investors answer the question “which stocks to buy?”. However, it does not tell them when to buy, which is required to create an effective long-term wealth creation strategy using stocks.
Bollinger Bands are an analytical tool designed to help us answer precisely this question.
Bollinger Bands decoded
Bollinger Bands consist of three trend lines – a middle line flanked by an upper line (band) and a lower line (band). The middle line is the Simple Moving Average (SMA) of the closing price of the stock in question, which is typically a 20-day SMA, but long-term investors can choose a 50-day SMA or of higher duration.
The first data point of a 50-day SMA is calculated by taking the average of the first 50 closing prices of the stock in question. The next data point is calculated by dropping the closing price as on day 1 and including the price as on day 51. And so on.
The upper and lower bands are formed by adding and subtracting two Standard Deviations (SD) from the middle band. Standard Deviation typically measures the variation in the data compared to the mean value of the data. In our case, it will be a measure of the volatility of the stock price.
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Standard Deviation is calculated as the square root of the average of the squared differences of each price point from the mean value of the price over the SMA duration. This is multiplied by two, and added as well as subtracted from the SMA value on each day to get the upper and lower bands.
How to use it in long-term investing
Once the Bollinger Bands are constructed, the daily price of the stock in question is plotted against them. When these daily prices start moving closer to the upper band, it indicates an overbought signal. When they start moving closer to the lower band, it indicates an oversold signal. Typically, long-term investors would prefer to accumulate their preferred stock whenever its price dips and accumulate the stock over the long term. This is called “buying on dips”. But not all dips indicate a buy signal.
This is where Bollinger Bands come in. Whenever you see a dip in prices that is continuously touching the lower band of the Bollinger Bands, it indicates a buy signal for a long term investor. This represents a “value buying” opportunity as the market is oversold on this particular stock.
Precautions while using it
Bollinger Bands by themselves are not foolproof indicators of buy or sell signals. They need to be used in conjunction with other momentum indicators like Moving Average Convergence Divergence (MACD) and Relative Strength Index (RSI) in order to triangulate buy or sell signals.
Note that, since the MACD and the RSI are used predominantly in technical analysis, these two momentum indicators require suitable recalibration to fit the needs of long term investors. This can mean that instead of taking 12 days’ or 20 days’ data, you would need to take 50, 100, or 200 days’ data for analysis.
Also, take care to factor in the overall market trends or stock price trends while interpreting the Bollinger Bands. This is because your interpretation and decision depend on your investment strategy. For example, for an investor who is following a ‘value investment’ strategy, mere indication of a buy signal by the Bollinger Bands may not suffice to take an investment decision unless the stock price is also in a downtrend.
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On the other hand, an investor following a ‘static asset allocation’ strategy may want to invest in the preferred stock at every buy signal from the Bollinger Bands, assuming his portfolio value has dipped with every dip in stock price.
By careful calibration and by superimposing the results of other indicators, you can use Bollinger Bands as a potent tool in your investment analysis kit.
The writer is founder, Hermoneytalks.com