Technical Indicators Tutorial : Volatility Indicators
Volatility shows how active a market is as reflected by the size of price ranges without specifying a price direction. An indicator such as Bollinger Bands reveals changes in volatility levels, which often lead changes in prices.
Bollinger Bands – Bollinger Bands are volatility curves used to identify extreme highs or lows in relation to price. They establish trading parameters, or bands, above and below a moving average at a set number of standard deviations from this moving average. Both the length of the moving average and the number of standard deviations can be modified to fit the market.
Traders generally use Bollinger Bands to determine overbought and oversold zones, to confirm divergences between prices and other technical indicators and to project price targets. The wider the bands on a chart, the greater the market volatility; the narrower the bands, the less market volatility.
Some traders use Bollinger Bands in conjunction with another indicator such as the Relative Strength Index (RSI). If the price touches the upper band and the RSI does not confirm the upward move (i.e. there is divergence between the indicators), a sell signal is generated. If the indicator confirms the upward move, no sell signal is generated – in fact, a buy signal may be indicated. If the price touches the lower band and the RSI does not confirm the downward move, a buy signal is generated. If the indicator confirms the downward move, no buy signal is generated – in fact, a sell signal may be indicated.
Another strategy uses Bollinger Bands without another indicator. In this approach, a chart top occurring above the upper band followed by a top below the upper band generates a sell signal. Likewise, a chart bottom occurring below the lower band followed by a bottom above the lower band generates a buy signal.
Bollinger Bands also help determine overbought and oversold markets. When prices move closer to the upper band, the market is becoming overbought; as the prices move closer to the lower band, the market is becoming oversold. Price momentum should also be taken into account. You should always look for evidence of price weakening or strengthening before anticipating a market reversal.