Interpreting Bollinger Bands

How do you know how to spot the bottom and top of a move? The answer lies in the following Bollinger band rules.

If the price exceeds a band, the trend is expected to continue. This is really another way of saying that if the price moves above the band, upside momentum is strong enough to support higher ultimate prices and vice versa.

The crossover of the Bollinger band usually indicates short-term exhaustion and it quickly pulls back again. However, this is just a process of pausing for breath until the trend is then able to extend again. By now, you will have noticed that the price often crosses the bands several times before the trend reverses. The obvious question at this point is: How do you know when the band has been crossed for the last time? In other words, how do you know how to spot the bottom and top of a move? The answer lies in the following rule.

When the price traces out a reversal formation after it has crossed outside a band, expect a trend reversal.

One of the basic assumptions of technical analysis is that stocks move in trends. Since major trends comprise many minor fluctuations in prices, an Moving Average is constructed to help smooth out the data so that the underlying trend will be more clearly visible.

Ideally, a simple Moving Average should be plotted at the halfway point of the time period being monitored (a process known as centering), but since this would involve a time lag during which prices could change rapidly and lose much of the potential profit of a move, the Moving Average is plotted at the end of the period in question.

This drawback has been largely overcome by the use of Moving Average crossovers, which provide warnings of a reversal in trend and by the use of weighted Exponential Moving Averages, which are especially sensitive to changes in the prevailing trend since they weight data in favor of the most recent periods.

There is no such thing as a perfect average. The choice of time span always represents a trade-off between timeliness (catching the trend at an early stage) and sensitivity (catching the trend turn too early and causing an undue amount of whipsaws). For short-term trends, 10-,25-,30-, and 50­day spans are suggested, but for longer-term time spans, 40-week simple and 65-week Exponential Moving Average averages are recommended. Helpful time spans using monthly data are 6, 9, 12, 18, and 24 months.