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Strike up the band (The Bollinger band)

I want to continue the discussion on indicators tonight by talking about Bollinger Bands.  This is yet another indicator that you can add to your arsenal. This indicator was developed by John Bollinger hence the name.

Bollinger bands are actually a set of indicators an upper and a lower that are used to compare the volatility within a stock and its relative pricing level. There is also a 3rd line that makes up the last part of the indicator; it is called the center line. The center line is a simple moving average.

You have heard me talk about a stock trading in channels before. Bollinger bands are a graphical way of depicting the channel. The upper band is resistance in the stock while the lower band is support. If you look at the bands on a chart you will typically see the stock trading back and forth within the channel that is created by the Bollinger bands. 

What typically starts to happen before movement in a stock is a tightening of the bands.  The stock begins to trade in a smaller trade range and the bands reflect this by tightening.  They will move in closer to the trade range of the stock. Since this is a volatility indicator as the volatility within the stock declines (the stock trades in a tight range) the bands naturally contract. 

If you look at a stock that has either just broken out or has broken down you will see just the opposite in the bands. They will have expanded out dramatically reflecting the sudden volatility within the stock.

We can use the indicator to find a stock that is poised to make a move. Since no stock can sustain a wildly volatile trade range over time we watch for the bands to tighten down.  You will see confirmation in the form of a break above or below the bands coupled with a move in the price of the stock. You can also use the indicator in just the opposite way.  A stock whose bands are about as wide as they can get is a prime example of a stock that has overextended itself either positively or negatively. Since that stock can not maintain the extreme volatility over time you can use the indicator to help identify stocks that are extremely oversold or extremely overbought.

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