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One useful tool in our trading toolbox is the Bollinger Band. Bollinger bands are upper and lower trading bands plotted at standard deviation levels above and below a moving average. Selecting a 2 standard deviation for the upper band and a -2 standard deviation for the lower band would mean, according to statistical theory, that 95% of all price observations would reside within these bands. 68% of all price observations would fall between these bands if a 1 standard deviation and a -1 standard deviation were used.
Does this mean we have discovered a fool proof method to predict stock prices? This is hardly the case. More realistically, Bollinger bands help us make more informed decisions in two ways. First, a time period such as 20 days is often associated with typical bands in most charting software.
This gives the trader an indication of where the stock price has been but not necessarily where it is going. When the price is reaching for the upper band, it is probable that a price correction is due. Probable is the key word here. Secondly, because of this use of standard deviations, the trader can determine visually whether or not consolidation or price volatility is occurring. A tightening band (consolidation) may signal an upcoming breakout while a widening band (volatility) may signal a change in price direction. May is the key word here.
As with many popular, technical indicators such as the 50 day moving average as well as Bollinger bands, the predictive value is proportional to the popularity of the indicator. The more traders looking at the signal, the more predictive it becomes. This is beneficial to a point as the market tends to absorb and adjust to methods that have saturated the trading world. Regardless, show me an upward trending stock with a consolidating set of Bollinger bands, and I will show you a profitable trade.