Bollinger Bands are a popular volatility indicator in technical stock market research. On a price chart, the bands represent three different lines, with the outer two representing a two-standard deviation range from a central line produced using a simple moving average. Bollinger Bands may be a particularly versatile and adaptive tool since the standard deviations broaden or shrink dynamically dependent on the security’s trading range. To validate the relative strength of a trend, it is typical to combine Bollinger Bands with another well-known indicator, the Relative Strength Index, or RSI.
The RSI is a momentum indicator that analyzes the amount of days a security closes higher vs lower over time. These values are then charted on a scale of zero to 100, with overbought equities normally predicted when the RSI exceeds 70 and oversold securities typically expected when the number falls below 30.
When the two are combined, the RSI may either support or demolish potential price patterns. For example, if a stock price approaches the top band of a Bollinger Band price channel while the RSI is reading 70 or above, the trader may conclude that the asset is overbought. The stock might then be sold, a put purchased, or covered calls sold.
Instead, suppose the price chart reveals that trade has reached the lower Bollinger Band and the RSI is not below 30. In this scenario, the RSI informs the investor that the investment may not be oversold, as the Bollinger Bands seem to imply. Because the decline may continue, the trader would not instantly initiate buy calls or acquire further shares. If the RSI is sufficiently high, the trader may even contemplate selling.
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