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Bollinger Bands

Pattern recognition is the process of recognizing recurring events. Patterns rarely repeat, if ever, in the
exact same manner. In general they look the same, and that is the problem. In order to be successful
with pattern recognition, some framework is needed wherein it can be analyzed. Bollinger bands are
one indicator that provides a very good frame work. Bollinger bands can help to identify rules which can
be used to interpret the formations. Definitions like new highs or new lows, sideways or volatile,
trending or trading. As the patterns evolve, the bands evolve right along with them, providing a relative
and flexible framework, rather than absolute, rigid frameworks imposed by the grid of a chart or trend
lines.
Markets seldom reverse in an abrupt manner. Usually reversals involve a sequence of price action which
includes one or more tests of support or resistance. Trend reversal patterns show the end of a
preceding trend and the start of a new trend. The new trend can be a reversal of a prior trend or a
transition from a trendless state. It can also be the beginning of a sideways trend or consolidation.
Most common reversal patterns are double tops or bottoms, head-and-shoulder patterns or three
pushes to a high. Some reversals can be brutal, and some dont turn out to be reversal patterns at all,
they just mark the end of the prior trend and a transition to a sideways market.
Bottom Reversals
A double bottom involves an initial decline followed by a recovery rally, and then a secondary decline
followed in turn by the initiation of an uptrend (Figure 1). When using Bollinger bands it is not
important whether the second decline makes a new low or not in absolute terms. As long as the first
low fall outside the lower Bollinger band, and the second low fall inside the lower band. The ideal
double bottom is a momentum low that occurs outside the lower Bollinger band, followed by a price
low inside the lower band. Even if the price low has made a new absolute low, it is on a relative basis
not a new low. The rally that follows can then be acted on without the emotions usually involved with a
new low in the market. Where the second low is higher than the first low, frustration is the main
emotion, traders waiting on the support for the re test are left behind while the stock rallies. When we
have a proper re-test traders are satisfied and rewarded quickly. When the second low is lower than the
first low, fear and discomfort comes to a trader. Once shaken out they seldom have the courage to get
back in.
When looking at a decline you will get an accelerated move into the first low with the highest
momentum and with the biggest volumes. After this the market should recover inside the bands and
sometimes even touching or tagging the mean (the middle line), followed by another decline
establishing the price low, which may be a new price low, but not necessarily, and will occur with less
momentum and less volume. Ideally volumes should be higher on the first decline than on the second.
Bottom reversals are generally cleaner and faster than top reversals. Bottoms are created in an
environment of fear and pain while tops are created in greed and euphoria. Bottoms are expected to be
sharper and more aggressive using less time, while tops should be more prolonged and less aggressive.
Down is faster - fear is a greater emotion than greed. The market falls on its own weight.

High Momentum
Decline

Recovery
Rally

Secondary
Decline

Initiation Of
New Trend

Irrelevant If Absolute
Low or Not

Figure 1

A similar top is not necessarily a perfect mirror of the bottom pattern. The top will most likely take more
time, and may consist of three upward thrusts, rather than just the two. Top reversals may play out as
triple top or a variation on head-and-shoulder pattern.
Once you have a trade that fits the double bottom, wait for the first strong bullish candle or ideally wait
for a candle reversal formation then enter into the trade in anticipation of a wave 1. The stop loss
should be placed at the most recent low that is the second low of the double bottom.
Lows outside the lower Bollinger band followed by lows inside the lower band are typical bottom
reversal patterns, even when there is a new price low. Highs outside the upper Bollinger band followed
by highs inside the Bollinger band are typical top reversal patterns, even when there is a new price high.
The top reversal may consist of three upward pushes instead of two.
Pattern recognition is the key to successful technical analysis.

Top Reversals
Top reversals are quite different from bottom reversals. Tops are more complex and mainly consist of
triple tops or three pushes to a high. Most common of all is the head-and-shoulders. There are spike
tops that reverse up trends just as panic bottoms reverse the down trend, but they are rare.

The classic head-and-shoulder pattern would be a left shoulder outside the upper Bollinger band
followed by a head that tagged the upper band, and the right shoulder that fail short of the upper band.
A very common variation of the head-and-shoulder is the three pushes to a high. The first push will be
outside the upper band followed by the second push making a new high, but only tag the upper band
without closing outside the upper band and then the third push making a marginal new high, or not but
will fail to tag the upper band.

Irrelevant If
Absolute High or Not
Could also be 3 pushes
to the high

Retracement

Secondary
Rally

Initiation Of
New Trend

High Momentum
Rally

Figure 2

To understand the Bollinger setup the rhythm of the market must be understood. The momentum of
the market is as always very important and the momentum need to be measured every time the market
approaches or breaking support or resistance levels. To be able to spot the early potential reversal
signal, what happens every time the price reaches the Bollinger band need to be studied. To identify the
occurrences as the market reaches the bands, three different terms will be used namely; close, tag and
failure. Figure 3 will demonstrate the three occurrences clearly before defining the different strategy
setups.

Bollinger Close
Bollinger Tag

Bollinger Failure

Figure 3

Figure 3 show the different occurrences on Bollinger bands.


Bollinger close:

When the price close below the lower band or closing above the upper band.

Bollinger tag:

When the price spike through the band but still closes on the inside of the band.

Bollinger failure:

Price action failed to tag or close outside the bands.

Bollinger Setups
By looking at the different events on the Bollinger Band mainly 3 types of setups can be recognised that
can predict potential trend reversals or potential wave ones.
The first setup involves a close followed by a tag while normal divergence is present. After spotting the
setup one has to wait for some form of confirmation before entering into a trade. Candle patterns
proved to be a very good entry confirmation. Once a candle pattern confirms the setup the trade may
be entered into. Mainly the target of a trade like this will be the opposite band. The opposite band will
Bollinger Trade Setup 1
Target

Candle Reversal
Enter into trade
Tag
Close
Indicator

Divergence

change after each session as the Bollinger bands expand right along with the price action of the
instrument.

The second setup involves a close followed by a failure while normal divergence is present. After
spotting the setup one has to wait for some form of confirmation before entering into a trade. Once a
candle pattern confirms the setup, the trade may be entered into. It is important that the price action
during a failure either touched the band or missed the band with a small margin. Failures not close to
the band will be worthless and may give false signals. Mainly the target of a trade like this will be the
opposite band. The opposite band will change after each session as the Bollinger bands expand right
along with the price action of the instrument.

Bollinger Trade Setup 2


Target

Candle Reversal
Enter into trade
Close
Failure
Indicator

Divergence

The third setup involves a tag followed by a failure while normal divergence is present. After spotting
the setup one has to wait for some form of confirmation before entering into a trade. Once a candle
pattern confirms the setup the trade may be entered into. It is important that the price action during a
failure either touched the band or missed the band with a small margin. Failures not close to the band
will be worthless and may give false signals. The target of a trade like this will be the opposite band.

Bollinger Trade Setup 3


Target

Candle Reversal
Enter into trade
Tag
Failure
Indicator

Divergence

Notice that all three the setups will be trades that is against the prevailing trend. Finding trend reversals
early is made easy using Bollinger bands. Remember once a normal divergence appears no trend
following trades can be entered into and the expectancy of a trend reversal does increase. Using only
divergence in the South African market is just not enough. The Bollinger band setup gives a very strong
signal that the trend can reverse now, and that there is a potential wave - one to capitalize on. Once
wave one is formed a normal trend following strategy can be followed again making the best of the
trend.
Remember that a failure followed by a tag is not a valid setup at all, the order is very important.
Trade the normal trend following strategy until normal divergence is spotted, then usually no trade
would be done and the share will not be on the watch list until a full wave one played out. With
Bollinger added, a trade is now possible to get into a trade before the trend reversal was confirmed,
helping to capitalise on a wave one.
Until next time!
Johan Malan