Bollinger Bands — Identifying Corrections, Tops and Bottoms

Many traders use Bollinger Bands to help them identify different stages of a market move including breakout points, continuation patterns, corrections and tops and bottoms.

There are some patterns that can forecast possible price movements that form during different stages of a move and when used with other indicators can raise the probability of that forecast.

Starting at the point where prices are in a squeeze and for this example we’ll assume prices decline. (Remember a squeeze is when prices are generally moving sideways and the bollinger bands squeeze together, when prices breakout of the squeeze the bands expand and move apart in opposite directions.) As prices move down, the bands will continue to widen, at the point when the top band begins to stop moving up and turns lower, prices tend to correct. Depending on the severity of the decline this could be a bottom, but is not necessarily. The more severe the decline the more the probability prices are in a correction. The top band will then continue moving lower with prices.

At the point when the bottom band begins to turn up is when the probability of prices bottoming increases dramatically. Prices are likely in another correction at this point and will move back to the 20 period moving average.

Other variables to keep in mind are the severity of the price decline, the steepness of the moving average, volume and the conviction of the correction. Also, momentum indicators are helpful to determine if a bottom is being made. Momentum will be sharply negative by this time, but if it begins to make a B-line for zero it raises the probability of a bottom.

In a steep decline the moving average is likely falling very steep as well. If the correction is relatively flat, rather than a V type correction, the probability of prices falling again after touching the moving average is high. What happens next is important, does the closing bottom bollinger band provide support as prices decline or does it turn lower. This will forecast prices for the short term. If the band provides support, price will move above the moving average and to the top band and a new squeeze and breakout point will emerge.

Remember, there is no pattern that is 100% full proof. Each pattern has its own characteristics, but similarities exist and with study, identifying these similarities will become easier.