In the s, John Bollinger, a long-time technician of the markets, developed the technique of using a moving average with two trading bands above and below it. Standard deviation is a mathematical formula that measures volatility , showing how the stock price can vary from its true value.
This is what makes them so handy for traders: Read on to find out how this indicator works, and how you can apply it to your trading.
The center line is an exponential moving average ; the price channels are the standard deviations of the stock being studied.
The bands will expand and contract as the price action of an issue becomes volatile expansion or becomes bound into a tight trading pattern contraction. Learn about the difference between simple and exponential moving averages by checking out Moving Averages: A stock may trade for long periods in a trend , albeit with some volatility from time to time. To better see the trend, traders use the moving average to filter the price action.
This way, traders can gather important information about how the market is trading. For example, after a sharp rise or fall in the trend, the market may consolidate , trading in a narrow fashion and criss-crossing above and below the moving average.
To better monitor this behavior, traders use the price channels, which encompass the trading activity around the trend. We know that markets trade erratically on a daily basis even though they are still trading in an uptrend or downtrend. Technicians use moving averages with support and resistance lines to anticipate the price action of a stock. Upper resistance and lower support lines are first drawn and then extrapolated to form channels within which the trader expects prices to be contained.
Some traders draw straight lines connecting either tops or bottoms of prices to identify the upper or lower price extremes, respectively, and then add parallel lines to define the channel within which the prices should move. As long as prices do not move out of this channel, the trader can be reasonably confident that prices are moving as expected. If the price deflects off the lower band and crosses above the day average the middle line , the upper band comes to represent the upper price target.
In a strong uptrend, prices usually fluctuate between the upper band and the day moving average. When that happens, a crossing below the day moving average warns of a trend reversal to the downside. For more about gauging an asset's direction and profiting from it, see Track Stock Prices With Trendlines.
In a couple of instances, the price action cut through the center line March to May and again in July and August , but for many traders, this was certainly not a buy signal as the trend had not been broken. In the chart of Microsoft Corporation Nasdaq: MSFT above , you can see the trend reversed to an uptrend in the early part of January, but look how slow it was in showing the trend change.
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