Your charting software may offer dozens or even hundreds of choices of indicators and oscillators for you to apply to stock prices and volume. Your job is to sift through all of these choices and to come up with a very small number of indicators that work for you. There are two very good reasons for selecting a minimal number of indicators. First, if you have too many indicators, you get data overload. You have more conflicting signals, and you need to try and figure out which indicators seem to be working best for a particular trade. Second, if you use one or two or three indicators, you can get a better feel for them - you can become an expert in how they react, and in what information they provide for you. The subtleties of each indicator will become more apparent, and you will be able to interpret them with better accuracy.
I have tried all of the indicators and oscillators provided by TradeStation, as well as a few dozen others that I have written, or that I've read about in books or magazines. Currently, my best success is with a combination of Bollinger Bands and MACD, as well as volume. If you are interested in using Bollinger Bands, I strongly recommend that you purchase "Bollinger on Bollinger Bands" by John Bollinger. This book goes into great detail about how Bollinger Bands work, how to use them, and why they are a good choice to help you make trading decisions.
There are several different categories of indicators. If you can select indicators that represent two or three categories, and you place trades when these indicators agree, you are getting signals that confirm each other, making the trade a more likely win. Ideally, you should also choose indicators that are not correlated - that is, they don't perform similar calculations on the same data, and give similar results. You want to select indicators that perform functions on different data (price and volume, for example), or perform different types of calculations that are not related (Stochastics and moving averages, for example).
These indicator categories are: Momentum (for example, Stochastics), Volume, Trending (for example, SMA or EMA moving averages, or MACD), and ways to measure extreme price divergence (RSI, Bollinger Bands, Volatility Bands). This final category identifies support and resistance levels based on how far the current price is from the "average" price. RSI gives you overbought and oversold indications, and Bollinger and Volatility Bands provide ranges for the current price, based on statistics, and the tendancy for the price to return to the "average".
Bollinger Bands use a statistical calculation (standard deviation) based on a Simple Moving Average. Charting Bollinger Bands, you will see three lines. The middle line is the standard SMA (default number of periods is usually 20). The upper and lower lines are determined by calculating the standard deviation (which is a measure of how volatile a stock price is, based on how quickly the price has moved away from the SMA). The default Bollinger Band setting is to use 2 standard deviations from the average, and so the upper band is calculated by adding 2 times the standard deviation to the SMA middle band, and the lower band is calculated by subtracting the same value.
Standard Deviation is used to identify statistical averages. In statistics, values within One standard deviation of the average include 68% of all values. Values within Two standard deviations of the average include 95% of all values. Therefore, what the Bollinger Bands are attempting to do is to provide upper and lower limits from the Simple Moving Average where the stock price is statistically unlikely to go. By using Two standard deviations, we can expect that the stock price should be between the upper and lower Bollinger Bands 95% of the time. In practice, Bollinger's book says that in most markets, the actual number is 88% to 89%. This information tells us several things. First, if the price goes outside of the Bollinger Bands, it's very unlikely to stay there for long - it would be a good time to exit a trade, or possibly to enter a counter-trend trade. Second, the distance between the upper and lower bands gives us a good indication of the current volatility. When the Bollinger Bands are in a Squeeze , where they are close together, a breakout (up or down) is likely to occur. The Bollinger Bands do not tell you when the breakout will occur, or which direction the price will go.
Applying Bollinger Bands in a trade11 September 2002 provided some excellent examples of trends that gave good Bollinger Band signals. Currently, I specialize in the Biotech and Semiconductor industries (and I dabble in a few others sometimes). The Semiconductors ($SOX) provided several examples today, including QLGC, NVLS, KLAC, and BRCM. I placed trades in NVLS and BRCM based on these signals. The 2-minute chart below shows almost perfect Bollinger Band signalling for NVLS. This day of trading was unusual because of the memorial ceremonies for the 11 September 2001 terrorist attacks. Nasdaq opened at 11:00 AM, and the NYSE opened at noon. Notice from the chart that NVLS (and many other stocks) opened extremely strongly, then drifted slowly upwards until noon. At noon, NVLS (and many other stocks) staged a reversal, as prices started to move down. Notice in the chart from 11:42 to 12:14, the upper and lower Bollinger Bands are closer together - in a "Squeeze" formation. This indicates that a breakout (or breakdown) will occur, eventually. During the Squeeze, the price moves from tagging the upper Bollinger Band to tagging the lower Band.
Trade 1: At 12:10, a two-green-bar reversal tags the SMA middle Bollinger line. The MACD indicates a downtrend. Also, the second green bar just penetrates a round number (26.00), and so I suspect that 26.00 offers good resistance. I place a Sell Short order at 26.00, during the second green bar at 12:12, with a stop at 26.10. The stock price moves up to 26.04, then drops quickly, and you can see the Bollinger Band expanding away from the middle 20 SMA line. Just as with using SMA lines, we expect the price to eventually return to the middle line. As the price rides the Bollinger Band down for several bars, I stay in the trade. I start to get nervous when the 12:20 long red bar significantly penetrates the lower Bollinger Band. When the 12:22 bar opens, and the price starts to reverse, I exit quickly, covering at the high of the 12:22 bar, at 25.43, for a 57 cent profit.
Trade 2: MACD still indicates a downtrend, so I don't try to swim upstream, and I watch as the price moves back up to penetrate the Bollinger 20 SMA middle line at 12:38. At 12:40, the price reverses, and I Sell Short at 25.64 with a stop at 25.76 (high of previous bar). I stay in the trade until the price penetrates the lower Bollinger Band again, I see a reversal at 12:52, and get out at 25.28 for 36 cents.
Trade 3: The price again reverses to tag the Bollinger middle line, and I get a third chance to short at 12:58 for 25.43, with a stop at 25.51 (I'm a big fan of round-number resistance and support). This trade rides the Bollinger Band until I see a Hammer candlestick pattern at 13:10, and exit in the next bar at 25.13, for 30 cents. This exit was a bit early, but looking at the MACD (showing no direction), and the slope of the middle Bollinger line starting to level off, I'm getting concerned that the stock may reverse in price (it moved into a 60-cent range consolidation pattern for the next couple of hours).
Looking at the chart, this is almost a picture-perfect group of trade setups. If you look at the other SOX stocks, as well as many others on 11 September, they will exhibit similar Bollinger characteristics, but some less clear than others.
The Bollinger Bands, in conjunction with MACD, and Volume (for additional trend confirmation) provide me a better-than-average set of indications of entry and exit into trades. After reading Bollinger's book, and understanding the motivation behind the Bollinger Bands, and how they work, I have a much better "feel" for the signals that they provide. Give them a try, and see what you think!
Good Trading!