Often, price trades at extremes, becoming excessively oversold. When that happens, an imbalance occurs in which a correction is needed to restore order to the true value of a given security.
Bollinger bands, popularized by John Bollinger, measure volatility in the form of highness or lowness of the price relative to previous trades. The closer a security is to its lower level, the more oversold it is, and the closer a security is to its upper level, the more overbought it is.
Bollinger bands adjust themselves to the market conditions so, as a result, these bands can be used as dynamic support/resistance levels for the underlying price action. Volatility tends to revert to its mean, and after price trades at the outer edge of a given band, it tends to trade back toward the median level represented by the mid-line moving average.
Another helpful indicator is %b. The %b indicator is derived from Bollinger bands, and represents a security’s price in relation to its upper and lower Bollinger band. The %b indicator can be used to identify overbought and oversold situations within the framework of Bollinger bands. However, it is important to know when to look for overbought or oversold readings. As with indicators, it is best to look for short-term oversold situations when the primary trend is up, and short-term overbought situations when the primary trend is down.
There are six basic relationship levels between %b and Bollinger bands:
- %b equals 1 when price is at the upper band
- %b equals 0 when price is at the lower band
- %b is above 1 when price is above the upper band
- %b is below 0 when price is below the lower band
- %b is above 0.50 when price is above the middle band (20-day simple moving average)
- %b is below 0.50 when price is below the middle band (20-day simple moving average)
Method & madness
When the trend is strong and price is trading above the mid-line moving average in the Bollinger band, it rarely will dip below that mid-line in what Bollinger calls “walking the band.” This is where price trades with conviction in a given direction without pulling back toward the mean, represented by the mid-line. “Walking the band” (below) illustrates this methodology in the Dow Jones Industrial Average.
In strong trends, prices can walk up the upper or lower band and rarely touch the opposite band. However, when price travels too far above the upper-line of the Bollinger band, it reverts not just to the mean but tends to overcompensate by snapping back in the other direction.