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A little information on Bollinger Bands

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Bollinger Bands plot trading bands above and below a simple moving average. The standard deviation of closing prices for a period equal to the moving average employed is used to determine the band width. This causes the bands to tighten in quiet markets and loosen in volatile markets. The bands can be used to determine overbought and oversold levels, locate reversal areas, project targets for market moves, and determine appropriate stop levels. The bands are used in conjunction with indicators such as RSI, MACD histogram, CCI and Rate of Change. Divergences between Bollinger bands and other indicators show potential action points. As a general guideline, look for buying opportunities when prices are in the lower band, and selling opportunities when the price activity is in the upper band.

Bollinger Bands are fixed lines drawn above and below a moving average of price and the width of the band varies with the volatility of the underlying security. Bands widen when the volatility of the security increases and contract when volatility decreases. Bollinger Bands are sometimes displayed with a third line. This is the simple moving average line. The time period for the moving average can vary, but John Bollinger recommends 10 days for short term trading, 20 days for intermediate trading and 50 days for long term trading. When price break through a band it usually indicates that the move is strong enough to continue further and sharp moves tend to occur when bands tighten. After hitting a band and not penetrating it the moving average of price will often be the next support or resistance area.

Bollinger Bands are envelopes that surround the price bars on a chart. Bollinger Bands are plotted two standard deviations away from a simple moving average. This is the primary difference between Bollinger Bands and envelopes. Envelopes are plotted a fixed percentage above and below a moving average. Because standard deviation is a measure of volatility, the Bollinger Bands adjust themselves to the market conditions. They widen during volatile market periods and contract during less volatile periods. Bollinger Bands become moving standard deviation bands.

Additionally, the standard deviation value can be varied. Many technicians increase the value of the standard deviation from 2 standard deviations to 2-1/2 standard deviations away from the moving average when using a 50 day moving average. Conversely, many technicians lower the value of the standard deviation from 2 to 1-1/2 standard deviations away from the moving average when using a 10 day moving average.

An important thing to keep in mind is that Bollinger Bands do not generate buy and sell signals alone. They should be used with another indicator. Many Traders prefer to use Bollinger Bands with RSI. This is because when the price touches one of the bands, it could indicate one of two things. It could indicate a continuation of the trend; or it could indicate a reaction the other way. So Bollinger Bands used by themselves do not provide all of what technicians need to know. Which is when to buy and sell. MACD can be substituted for RSI.

However, when combined with an indicator such as RSI, they become quite powerful. RSI is an excellent indicator with respect to overbought and oversold conditions. Generally, when price touches the upper Bollinger Band, and RSI is below 70, we have an indication that the trend will continue. Conversely, when price touches the lower Bollinger Band, and RSI is above 30, we have an indication that the trend should continue.

If we run into a situation where price touches the upper Bollinger Band and RSI is above 70 (possibly approaching 80) we have an indication that the trend may reverse itself and move downward. On the other hand, if price touches the lower Bollinger Band and RSI is below 30 (possibly approaching 20) we have an indication that the trend may reverse itself and move upward.

Above, I've talked about the use of a second indicator to work with Bollinger Bands. Avoid the trap of using several different indicators all working off the same input data. If you're using RSI with the Bollinger Bands, don't use MACD too. They both rely on the same inputs. You might consider using On Balance Volume, or Money Flow. RSI, On Balance Volume, and Money Flow, rely on different inputs. They measure different things. They can be used together as further confirmation of a trend. The technical term for this is 'Avoiding Multicolinearity'.


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