John Bollinger, author of the new book Bollinger on Bollinger Bands, invented this indicator. These bands are drawn above and below the price structure on a chart and are designed to contain approximately 90% of all price action.

Calculating Bollinger Bands

A 20-period simple moving average (20 is the default length, but it can be adjusted to suit your trading style) is known as the "middle band." The upper and lower bands measure the volatility of the chart by applying a standard deviation formula to the same data as were used for the middle band. You can refer to Bollinger's book for the precise formula. Here, it is enough to say that the upper and lower bands are each two standard deviations from the middle band, and they expand on increased volatility and contract on decreasing volatility.

The beauty of Bollinger Bands is that they are a measure of "relative" price levels, rather than absolute levels. For example, if a closing price of $10 were below the lower band, $10 would be considered lower than a closing price of $9 that closed higher than the lower band. While $10 is higher than $9 on an absolute basis, it is lower on a relative basis.

Using Bollinger Bands

Because most of the price action is contained within the bands, the most common use of Bollinger Bands is to buy when price touches the lower band and sell when price touches the upper band. However, this simple method really sidesteps much of the usefulness of the bands. Because prices often trade along either the upper or lower band for an extended period of time (this is known as "walking the bands"), using just this simple method can often take you out of a profitable trade too soon, or put you into a losing trade when you should stand aside.

So how do we use the relative nature of Bollinger Bands for more profitable trading in the days ahead? Well, let's assume that the Dow will either pull back on profit-taking, or perhaps even retest the recent lows. By using Bollinger Bands, we focus on the new low relative to the lower Bollinger Band, and not relative to the previous price low. A lower relative level indicates a failure and should not be bought. A higher relative level is a successful test (even if that close is actually at a lower price level than the previous bottom), and provides a good risk/reward long entry.

Confirming Indicators

One of the toughest trades is to buy when a new absolute price low is reached. But by using other indicators in conjunction with Bollinger Bands, you can confirm the viability of the trade. For example, I recently wrote two articles on the use of Wilder's Relative Strength Index, or RSI. RSI can be used to measure whether a chart is overbought or oversold. Like Bollinger Bands, RSI should be used on a relative basis.

Successful Retest:

Price: Higher low -- relative to Bollinger Bands -- even if the next low is actually lower in price than the previous low; and
RSI: Higher low, relative to previous low RSI reading.

Unsuccessful Retest:

Price: Lower low -- relative to Bollinger Bands -- even if the next low is actually higher than the previous low; or
RSI: Lower low, relative to previous low RSI reading.

Look at an updated chart of Procter & Gamble (PG Quote) -- there is one in my first RSI article -- for a current interpretation using Bollinger Bands. You will notice that I projected some "hypothetical bands" to demonstrate two possible scenarios using Bollinger Bands: (a) failed test, even though the price does not set a new absolute low; (b) successful retest, even though the price closes lower than the Sept. 21 low.

Volume is a key component of any trade (remember the old saying: Volume precedes price). Study the relative volume on the second pullback. Is it heavier or lighter than during the previous low? Lighter volume is another indication that the second pullback can be bought. However, heavier volume usually confirms the strength of the selloff. But remember that technical analysis is not foolproof and should instead be used to tilt the risk/reward ratio in your favor. While Bollinger Bands are certainly useful when used by themselves, they work much better along with other indicators.

In the coming days and weeks, use Bollinger Bands to gauge the relative nature of any pullback. I think you'll find them essential in determining whether you're buying a real bounce, or catching a falling knife.