Imagine that you have decided to purchase a stock or ETF as an investment. You have done your research and know the stock has a history of healthy growth that keeps up with the overall stock market.
The next question is when to make the purchase. Answering this question also requires some easy use of charts.
Before looking at a stock chart, let's consider a chart with very similar math that more people are more familiar with: the CDC growth chart for a boy growing from being a toddler to a young man.
On this chart height is shown on the top set of curves and weight is shown on the bottom set of curves. Age increases from left to right as we look across the chart.
The CDC only considered healthy children when building this chart. The middle curve in each set shows how an average healthy baby grows. It is marked 50 because 50% (half) of healthy children of that age were that tall or less, or that heavy or less.
The other curves on the height portion that are above or below the middle curve represent taller or shorter healthy boys. For example, the top-most height curve is marked 95 because 95% of all healthy boys were that height or less.
The other curves on the weight portion that are above or below the middle curve represent heavier or lighter healthy boys. For example, the bottom-most weight curve is marked 5 becaue 5% of all healthy boys were that weight or less.
Focus on the fact that all of the curves show normal and healthy boys. There is nothing alarming about a shorter boy that grows along the 5% curve. What would be alarming is if a taller boy stayed at the 90% curve for many years and then suddenly dropped down to the 50% curve: perhaps that boy became ill or malnourished and is not growing well.
We can also make statements about boys of a specific age. Consider this close-up of weights for eighteen- and nineteen-year-old boys.
The blue circle shows that the average weight for nineteen-year-old boys is about 151 pounds. In other words 50% (half) of nineteen-year-old boys weigh 151 pounds or less.
The brown circles show that most nineteen-year-old boys weigh between 122 and 198 pounds. Ten percent weight more than this (above the 90% curve). Ten percent weigh less than this (below the 10% curve). But the remaining eighty percent are in that range.
Now I will introduce some special and (at the moment) slightly inaccurate vocabulary. Let us name the middle 50% curves the moving averages because they are averages that "move" as the healthy boys measured by the CDC get older. We will also name the top and bottom curves labeled 95 and 5 the Bollinger Bands, and ask John Bollinger to forgive us for the moment.
Why are we slightly inaccurate? A real moving average uses informaction collected by measuring one group at many different times. But the CDC did not do this. The CDC did not pay attention to one group of boys for eighteen years, measuring them every few days. Instead, the CDC measured lots of boys of all different ages at one time in the year 2000. This was obviously a more practical way to collect the information. But it does mean our "moving average" is untraditional.
Similarly a real Bollinger Band measures where the moving average has spent ninety percent of its time during the twenty days. But the result looks a lot like the top and bottom growth chart curves.
Now let's look at a stock chart for a company everyone has heard about, Walmart. (This company is used in the example because its chart clearly shows the math we are discussion, not because of its investment potential.)
This is a stock chart for Walmart in December 2013, going back in time two years. You can click on it to see a larger version.
This chart has four lines.
The very wiggly blue line that is shaded underneath is what the stock costs. The cost changes from second to second whenever to stock market is open. Unlike a healthy growing boy, it goes down as well as up.
Why do stock prices wiggle? No one knows what a big company is worth! How much is the company earning? Will its newest policies really help it do business? Does it have any innovations or inventions that will be released soon and will make a difference? Does the company make any flawed products that will create a costly recall? Will changing state and Federal laws help or hurt the company? Will any of the company's rivals become more or less competition? These and other questions mean that all investors are guessing about whether or not the stock price is a good deal. That wiggly blue line that is shaded underneath shows these guesses.
The smoother blue line is the moving average. It shows the how the average guess changes with time.
The upper green line and the bottom red line are the top and bottom Bollinger Bands. Just like the top and bottom curves on the growth chart, they show the boundaries of normal and healthy guesses.
If you knew nothing about a normal and healthy boy, you could still expect that boy's height and weight to probably be in between the top and bottom bands on the growth chart. Similarly, the actual value of a company is probably in between the top and bottom Bollinger Bands.
The numbers for the prices are at the right hand edge of the chart. When this chart was made, the four prices were:
So the actual value of one share of Walmart is probably between $76.51 and $82.01. The average guess recently made by investors is $79.26. The very most recent guesses were $77.87.
Notice that the wiggly stock price almost always stays in between its Bollinger Bands. This makes sense because any values outside the Bollinger Bands are in some way abnormal or unhealthy. Such an extreme guess might be correct! Perhaps the company is about to really benefit from releasing a new invention. Perhaps it is about to suffer from a change in Federal laws. But those type of extreme circumstances are rare. Stock prices normally bounce around in between their Bollinger Bands.
Ta da! We just answered our original question! The best time to buy a stock is when the current price is close to the lower Bollinger Band, below the moving average. Those situations look like this Walmart chart.
Imagine that we purchased one share of Walmart stock in the situation pictured by our chart. The current price might dive down below the red line. We would lose money! But it is much more likely that the current price goes up toward the moving average. Our long-term profit will be slightly higher than if we had purchased the stock earlier in the month when the current price was crossing the moving average (at about $79.90).
When the current price is near the upper Bollinger Band we should wait a few days to buy the stock. This might be a mistake. Perhaps the current price shoots up and stays up, and we could have enjoyed that rise as part of our profit. But it is much more likely that the current price is about to go down a bit. Our long-term profit will be slightly higher if we are patient and wait for that upcoming dip to happen. Investors who purchased Walmart stock on December 1st, 2013 paid $81.00 to do so. They should have looked at the Bollinger Bands and waited a few days.
Note that these guidelines are not foolproof. Towards the end of May any investors who purchased Walmart stock when the current price touched the lower Bollinger Band were disappointed. But since we are only disucssing stocks (or ETFs) that do well long-term, even investors who are unlucky about Bollinger Bands and lose out short-term are still happy long-term.
Moreover, most of the occasions when the current price continues to decrease past the lower Bollinger Band are newsworthy. An investor should read the current investment-related "market news" about a company (or ETF) before making a purchase. In May, when the chart shows the current price of Walmart stock was decreasing so much, the company was facing scandals about factories in Bangladesh and about bribery. In only few minutes an investor could learn that the company was in trouble, its current price had serious reasons for dropping, and the usually rare case of diving below the lower Bollinger Band was actually quite likely.
Selling a stock involves similar but opposite timing.
The behavior of the stock chart is never a reason to sell the stock. We pick which stock to buy because we have money to invest and we are confident that particular stock will keep up with the market and has a history of doing even better than the S&P500 index. Similarly, we pick which stock to sell because we need money or because that particular stock has stopped performing at our standards.
We time our stock buying to happen when the current price is near the lower Bollinger Band when the current price is near a short-term minimum. Similarly, we time our stock selling to happen when the current price is near the upper Bollinger Band when the current price is near a short-term maximum.
The Bollinger Band guidelines are not foolproof. When buying, we should read some market news to double-check that we are not buying when some newsworthy event is still pushing the current price down. When selling, we should read some market news to double-check that we are not selling when some newsworthy event is still pushing the current price up.
Pretend you have decided to buy some stock in the company Seagate, which manufactures computer hard drives and is usually a good investment. Is today a good time to do so?
Visit the Google Finance web page. In the top search box (which tells you it will search finance instead of the entire internet) type "Seagate". As you type, it suggests investments. You will see that the stock symbol for Seagate is STX.
Your search will bring you to a page about Seagate, dominated by an interactive chart at the top.
Click on the word "Technicals" at the bottom of the chart. A menu appears. Pick "Bollinger Bands".
The menu also asks for a number that is the "Period". Use 20 of you are in a rush to buy the stock. Use 40 or 60 if you do not mind waiting several weeks or months. A larger number hugs the current price less. There will be fewer recommended times to buy, but the few that remain will be more reliable.
How does the current price for Seagate compare to its moving average and lower Bollinger Band? Is today a good day to buy Seagate?
To the right of the chart is some market news relevant to the company. If the chart suggests that today is a good day to buy Seagate (because the current price is below the moving average and near the lower Bollinger Band) does the market news explain why? Is the company facing trouble or scandal or increased competition?