Bollinger bands were created by the technical analyst John Bollinger in the 1980's. They are a measurement of price volatility.
They consist of three “bands”. The middle band is a 20-period moving average. The upper band is 2 standard deviations above the middle band and the lower band is 2 standard deviations below the middle band.
When taken together, these three bands give you a clear picture of the “normal” range of motion for a stock's price.
When the price rises above the upper band, it means that it has risen above the normal range of volatility. This means the price is likely to fall. When the price falls below the lower band, it means that it has fallen below the normal range of volatility. This means the price is likely to rise.
One way to trade using bollinger bands is to short a stock whenever the price gets above the upper band. In this case, you can place a take-profit point at the middle band and a stop-loss just above the current price.
Another way is to go long whenever the price is below the lower band. In this case, you can place a stop-loss just below the current price and a take-profit at the middle band.
However, back-testing has shown that these trading strategies usually don't work very well. This is because the price often moves further outside of the bands before snapping back into it again. So it's easy to get stopped-out and then have the trade go in your favor (after you've already exited).
Because of this problem, I'm going to give you a more nuanced strategy that I've found to be more effective.
Having the price go below the bollinger band is an indication that a stock is oversold. However, sometimes trader sentiment is still strong even though a stock has fallen dramatically.
In such a case, going long is risky because there are a lot of buyers that have not given up yet. Should they see something they don't like, they may change their minds and let the stock fall further.
However, you can get a good idea of trader sentiment by paying attention to websites that aggregate social media postings about stocks, such as stocktwits.com. You can also just search for a stock's ticker symbol using hashtags on Twitter or Facebook to get similar information.
If you find that the majority of posts are bullish, this is a sign that the stock may fall further before it snaps back. But if you find that the majority of the posts are bearish, this means most traders have capitulated.
In this case, everyone who was going to sell has already done so. And the stock is ripe for a bounce.
If you want to find oversold stocks that are ready to bounce, bollinger bands are a great indicator to use. But it's not easy to consistently have winning trades with them.
Follow this strategy to increase your odds.