Three Bands Encompassing

Again, this indicator consists of three bands encompassing¬†a security’s price action. Defaults are:

 

1. A simple moving average in the middle, usually 20 days for intermediate investing.

2. An upper band ( 20 day SMA plus 2 standard deviations)

3. A lower band (20 day SMA minus 2 standard deviations)

 

Standard deviation is a statistical term that provides a good indication of volatility. Using it

ensures the bands will react quickly to price movements and reflect periods of high and low

volatility. Sharp price changes and hence volatility, will lead to a widening of the bands.

Closing prices are usually used to compute Bollinger Bands. Other variations can also be used.

The length of the moving average and number of deviations can be adjusted to better suit

individual preferences and specific characteristics of a security.

 

One method to determine an appropriate moving average length is a visual assessment. Bollinger

Bands should encompass the majority of price action, but not all. After sharp moves, penetration

of the bands is normal. If prices appear to penetrate the outer bands too often, then a longer

moving average may be required. If prices rarely touch the outer bands, then a shorter moving

average may be required.

 

A more exact method to determine moving average length is by matching it with a reaction low

after a bottom. For a bottom to form and a downtrend to reverse, a security needs to form a low

that is higher than the previous low. Properly set Bollinger Bands should hold support

established by the second (higher) low. If the second low penetrates the lower band, then the

moving average is too short. If the second low remains above the lower band, then the moving

average is too long. The same logic can be applied to peaks and reaction rallies. The upper band

should mark resistance for the first reaction rally after a peak.

 

In addition to identifying relative price levels and volatility, Bollinger Bands can be combined

with price action and other indicators to generate signals and foreshadow significant moves:

 

Double bottom buy: A double bottom buy signal is given when prices penetrate the lower band

and remain above the lower band after a subsequent low forms. Either low can be higher or lower

than the other. The important thing is that the second low remains above the lower band. The

bullish setup is confirmed when the price moves above the middle simple moving average.

 

Double top sell: A sell signal is given when prices peak above the upper band and a subsequent

peak fails to break above the upper band. The bearish setup is confirmed when prices decline

below the middle band.

 

Sharp price changes can occur after the bands have tightened and volatility is low. In this

instance, Bollinger Bands do not give any hint as to the future direction of prices. Direction must

be determined using other indicators and aspects of technical analysis. Many securities go

through periods of high volatility followed by periods of low volatility. Using Bollinger Bands,

these periods can be easily identified with a visual assessment. Tight bands indicate low

volatility and wide bands indicate high volatility.

 

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