Recently I showed you my favourite charting tool – Bollinger bands. In my experience, adding this simple overlay to your stock charts can make a massive difference when you trade. And it’s great to hear many readers reporting they’ve taken to it already.
But as with any tool, it’s only as good as the way you use it.
So having shown you how fantastic Bollinger bands can be, today I want to show you where they can let you down. I’ll point to a critical flaw in this tool. And that will lay the groundwork for a fantastic stock that I'll present to you on Friday.
When Bollinger goes wrong
Last week I told you that I’ve got a super-exciting stock I want to let you in on. It’s an oil exploration stock. And to my mind, it’s been dragged down to massively undervalued levels.
I first started looking into this stock well over a year ago. At the time it was trading at around $10. And the great and the good of the industry were talking the stock up to $20 or more!
I was certainly interested. I know the industry, and I know a bit about the guys behind this stock. I knew this was serious stuff. Yet as I followed the stock - the news-flow, director deals and the all-important drill results - it fell further and further.
So I stuck to my principles (never buy a stock when you first learn about it) and I’ve diligently watched on from the sidelines.
In fact, when I wrote to you last week, I thought it had already plumbed its lowest depth. Trading, as it was, around $1.30, the price was well below the value of its cash. Surely it couldn’t go any lower? Yet this week it broke the buck, as I write it’s trading at 99 cents.
Thank heavens I didn’t use Bollinger for this one…
An exclusive report from The Right Side
Take a look at this chart
What we have here is a chart of the oil explorer over the last six months. Notice how for most of the last six months, this stock has been trading at, or near the bottom of its range. Bollinger tells us it’s a good time to buy... and yet it keeps on falling! Why is that?
It’s all down to the way the Bollinger is calculated.
Effectively, the bands are a moving target – they show you the stock’s deviation from its recent average. In this case, as the stock moves down, the bands follow. And it reveals a flaw to my beloved Bollinger... they don’t work very well if a stock is constantly falling, or constantly rising.
If that average keeps moving in one direction, it skews the whole picture. And as a trader, this is the sort of fly in the ointment you need to know about.
The best way to use Bollinger bands
No charting tool is perfect. Bollinger bands can be fantastic for timing your trades. But it’s dangerous to rely too heavily on it.
That’s why I only use them in conjunction with fundamental analysis. That is, I like to get to really know a company before I invest. And if there is a really compelling case for investing, I’ll then use my Bollinger bands to help me time my investment.
I think that the company I’m going to show you on Friday has a very compelling investment case. Over the coming year it’s drilling wells off the coast of Africa and onshore Brazil. And if they make a discovery, the stock could really fly.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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