How to Trade S&P 500 Stocks with Bollinger Bands®

How to Trade S&P 500 Stocks with Bollinger Bands®

In an earlier newsletter we discussed some of the advantages of using the members of the S&P 500 as your trading universe. One effective way to trade S&P 500 stocks is by using a strategy based on Bollinger Bands ®, like the one we described in the Strategy Guidebook Trading with Bollinger Bands ® – A Quantified Guide.

Bollinger Bands®, created by legendary money manager and researcher John Bollinger, are one of the most popular trading indicators in use today. Nearly all commercial charting applications include the ability to plot Bollinger Bands®, which allow traders to quickly assess how overbought or oversold a security is.

Bollinger Bands® are a measure of volatility. When volatility is low, the bands contract around the security price. The bands expand as volatility rises. Furthermore, a security whose price is approaching the lower band is considered oversold, while a security whose price is near the upper band is considered overbought. So how are these bands calculated?

The Bollinger Bands® calculation begins with a simple moving average of the security price. In our research we use the daily closing price for this calculation. We have found that a 5-period moving average, or MA(5), is an excellent basis for many Bollinger Bands® trading strategies.

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Next, we determine the standard deviation of the price over the same number of periods used for the moving average, which in our case is five. We can refer to this value as SD(5).

Finally, the Bollinger Bands® are calculated by adding (for the upper band) or subtracting (for the lower band) some multiple of SD(5) to the MA(5) value. Our Bollinger Bands® trading strategies always use a multiple of one, whereas most charting applications default to a multiple of two. In summary, that gives us:

Upper Band = MA(5) + SD(5)

Lower Band = MA(5) – SD(5)

%b is an indicator derived from Bollinger Bands®. The %b value quantifies a security’s price relative to the upper and lower Bollinger Bands®. Our research has consistently shown the %b component of Bollinger Bands® to be an excellent way to determine entry and exit triggers.

%b = (Price – Lower Band) / (Upper Band – Lower Band)

Note the following qualities of %b:

    • %b equals 1 when price is at the upper band
    • %b equals 0 when price is at the lower band
    • %b is greater than 1 when price is above the upper band
    • %b is less than 0 when price is below the lower band
    • %b is greater than 0.50 when price is above MA(5), i.e. the middle band

%b is less than 0.50 when price is below MA(5)

Assuming that you have a Bollinger Band® %b strategy that you like, the new Trading Markets Live Screener can help you find trade candidates. The %b filter can be found on the Technical tab. As always, you can also set other filtering criteria that correspond to your strategy, for example by setting the Index filter to “S&P 500” on the Price / Profile / Volume tab.

Because the screener updates all indicator values throughout the day, there are multiple ways to use this powerful tool. If you like to enter trades at the close of the trading day, check the screener 20 or 30 minutes before the close to see which stocks or ETFs currently meet your filtering criteria. Now you have a short list of candidates to work from, and you can place your end-of-day orders appropriately.

Some traders like to enter trades intraday, and the Screener is a great tool for this as well. Indicators often reach extreme levels during the trading day before reverting back to less extreme values at the close. Looking for very low (oversold) or very high (overbought) intraday values of %b may help you find attractive trade candidates that could disappear by the end of the trading day. You might also consider entering an initial position when you see these extreme intraday values, and then either scaling in, holding, or exiting at the close depending on the direction and magnitude of the price move during the remainder of the day.