One of my favorite overlays to use on my charts is a tool developed by John Bollinger that is likely well-known by many who implement Technical Analysis (TA). Bollinger Bands have been a rather useful overlay, and I have found some success when correctly using them in my trading. For an overview of this charting tool, I would review the embedded link in this text. The featured charts in this post use the standard metrics—the white dotted lines on either side represent two standard deviations, and the solid white line is the simple 20-period moving average (20 sma).
To clarify, two standard deviations represent 95% of all price action above/below the 20 sma—therefore the bands capture 90% of all “normal” price action. These charts are all on the daily timeframe.
I have found that Bollinger Bands are good overlays for measuring relative tops and bottoms. One cannot simply sell when price hits the top band or buy when it hits the bottom band—it is never that easy.
Take a look at the below chart of the Dow component Caterpillar (CAT). On this Monday, 2/25, you can see the long red candle where CAT broke down below its lower band. The following day, some of the losses were recovered and CAT formed what is known as a hammer formation. For those not into candlestick theory, a hammer is bullish reversal pattern where the “head” is about 1/3 of the wick of the candle. The long lower shadow on 2/26 indicated that sellers pushed the price lower throughout the day, but buying power was stronger and bulls were able to push the closing price up near the highs.
This is a “textbook” pattern—especially when it is used in conjunction with the Bollinger Bands. Big buying volume makes it even more compelling that a short-term bottom has been established. Furthermore, it is also important to not “jump the gun” and initiate a trade before you have any confirmation/follow through. The following day (chart featured below on 2/27), CAT traded higher right from the open and printed a very bullish candle by 4 PM. Had you entered early in the trading day, this would have made for a profitable short-term trade.
There are an infinite number of ways to use Bollinger Bands, and this is merely a simple example of how I have used them in conjunction with other methods of analyzing price action. Various methods will work for different traders, but remember that no single indicator or overlay will work solely by itself.