Effectiveness of Bollinger Band in Signaling Essay Example for Free

Effectiveness of Bollinger Band in Signaling Essay Financial markets are the most difficult markets to operate in when determining the price at which stocks (bonds and foreign exchange are trading). Since stocks trade for long duration of time, traders need to know the appropriate time to buy or sell their stocks. To do this, they must have perfect information on the trends in the market through the market indicators. These indicator are always not obvious and at times require technical devices to show exactly how the trend of a particular stock ha been moving for a period of time (Bollinger 56). A trader can calculate deviations of the prices of that particular that he/she intends to trade and observe it. Though this is one way of observing the indications of stocks in financial market, there have been other means of observing the trends which are easier to use. One of these is the Bollinger Band which was developed by John Bollinger in the early 1980s (www. investopedia. com ). Bollinger band is a technical indicator of a stock in the financial market which consists of a centerline/middle line and two bands that indicate the deviations of the stock’s performance in the market from their pre-determined true trading value (Bollinger 56). These two bands indicate whether the stock was over-trading or under-trading. The upper band indicates the extent at which the prices went above the true value while the lower band indicates the extent at which the prices went below the true value. Through such indications, traders know when to sell or when to buy and make profits. When the upper band is high above the middle band, it means that the prices are high above the true value and when it is below the prices are lowest below the true value. These bands only show indications and they are not actual buying or selling prices. When the band is high, it is said to be expanding such that traders would want to sell the stocks while the band is below the centerline it is said to be contracting and the traders would be willing to buy the stocks (Murphy 344). Bollinger bands technique is used along with other techniques (like the Profit Magic of Stock Transaction Timing and Dow Jones Industrial Average) to give the best results in stock trading. This technique is very effective in that accurate trends can be observed since the bands adapt dynamism as the prices go up or down. The stock price is said to oscillate between the two bands (Murphy 348). They can also be customized to meet each traders needs. Bollinger bands can be set in a way that they only show what each trader needs in the market and hence the kit focuses on a wide range of investor in the financial market ( http://biz. yahoo. com ). They also show whether the prices are high or low and hence indicating the range of how the price had moved in the market. This enables investors to know when to lay off some of their stocks and when to acquire more. Mostly they would acquire more when the prices are below the centerline and shed-off or sell more when the band is above the centerline. And when the price is very much close to the centerline meaning that the prices have not deviated from the true price of that particular stock, no action should be taken (Bollinger 92). Bollinger bands are also consistent since they use the moving average which is used in calculating standard deviation. Thus they give reliable information and at times investors need not require other technical analysis in making their sell and buy decisions (The Quarterly Journal). The Bollinger band also captures much data and hence at a glance one can tell the trend of the stock much faster. Below are examples of analysis of international stocks to show how effective the Bollinger bands are: Intel Corp analysis for 2006: Intel’s lower Bollinger band closed below the centerline on Dec. 22, 2006 and this was a signal for over selling of the companies stock. (www. investopedia. com ). New York Stock Exchange: On June 12, 2006 the stocks broke the lower Bollinger band indicating that there was over selling. Through these signal technical traders would place orders to buy. The Bollinger band showed the extreme end of its lower band the following day putting much pressure for investors to sell. Yahoo! : On Dec 20th, 2006, Yahoo Company’s stock lowered the band which called for more buying. (Lifted from StockCharts. com) The chart shows that there was selling pressure on the stock and it turned out that most people were selling their stocks whereas the strategy was that of buying. Though Bollinger band analysis in the stock market has advantages, there are situations when this method does not give the expected results and it turns out that the market is operating in the opposite direction. Even if this is the case, the bands still oscillate and the trends will continue to show but the prices do not change quickly and thus the effects are not that severe. Over time, since stocks trade for long periods of time the strategy will be correct and the trading goes back to normal (Rachev et al 126). IBM: For instance, on February 26th 2007 IBM was trading below the lower Bollinger band. This meant that the pressure was mounting and forcing the technical traders to sell more. Since the prices were that low, the strategy was to buy stocks the following day on which it turned out that the day was trading low (The Quarterly Journal). This was abnormal in financial markets and this led to down fall of the stocks even greater. (Lifted from StockCharts. com) The stocks were sold well and the business would close below the lower band till March 5th when the selling pressure ceased. This resulted to the band starting to expand and approaching the centerline although huge losses had already been incurred. Apple Inc: On 21st December 2006, Apple closed below the lower Bollinger band which required that stocks be bought the following day. The stocks traded on the lower band and thus the selling pressure continued to take the stocks down. This trend continued until 27th December when some relief was felt. (Lifted from StockCharts. com) In conclusion, Bollinger Bands are just like moving averages which contradict and expand as they move. As they move they form unique patterns that investors are able to observe. Bollinger bands are used as signals of when to sell or buy a stock in the financial markets. Though used as signals, they are not the final indicators as to whether the stocks are to be traded but other factors need to be considered (Schlossberg). These bands are easy to use and one need not go for classes to learn about how to use them in making decisions about stocks. Since prices in the short run are not predictable, investors cannot make decisions based on short-term period but since Bollinger bands are a reflection of a longer period of time, they can make their decisions on that (Schlossberg). List of References John Bollinger: The eSignal Bollinger Band Tool Kit, accessed on 25th September 2008 from http://www. esignal. com/solutions/studies/bollingerband_article. aspx , John Bollinger: Bollinger on Bollinger Bands: McGraw-Hill Companies. 2001 John Devcic: Tales From The Trenches: A Simple Bollinger Band Strategy: accessed on 25th September 2008 from. http://www1. investopedia. com/articles/trading/07/bollinger. asp Boris Schlossberg: Using Bollinger Band Bands To Gauge Trends: Accessed on 25th September 2008 from 38. 102. 154. 10/articles/trading/05/022205. asp Bollinger Charts lifted from StockCharts. com on 25th September 2008 John J. Murphy: Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications: New York Institute of Finance,Prentice Hall Press. 1999 324-430 The Quarterly Journal of Business and Economics, Spring 2007 Bollinger Bands: Accessed on 25th September 2008 from http://biz. yahoo. com/charts/guide13. html . Rachev; Svetlozar T. , Menn, Christian; Fabozzi, Frank J. , Fat Tailed and Skewed Asset Return Distributions, Implications for Risk Management, Portfolio Selection, and Option Pricing, John Wiley, New York (2005) 123-145 Technical analysis in the forex / Bollinger band : Accessed on 25th September 2008 from www. forexchannel. org/technical_analysis/bollinger_band/