Editor’s note: See this month’s Getting Technical for an exclusive SFO interview with John Bollinger.
Bollinger bands, developed by John Bollinger in the early 1980s, are an attempt to determine overbought and oversold price levels. Rather than using absolute levels, bands representing two standard deviations are placed around a 20-period moving average. Using two standard deviations captures 95 percent of the price deviation around the mean.
The theory is that once price reaches a band or exceeds it, then the asset is overbought for the upper band or oversold for the lower band. However, a breakout above or below the band can also signal a new upward or downward trend.
The Carlson confirmation model (CCM) provides a basis for determining whether the current high or low is an extreme to be faded or a new trend to be bought.
ADDING A TOOL
The second primary indicator in the CCM is the Relative Strength Index, or RSI. It was developed by J. Welles Wilder Jr. and presented in his 1978 New Concepts in Technical Trading Systems. In the book, Wilder recommends using 14 periods. The RSI is a momentum oscillator that measures the strength of an asset relative to itself (as opposed to another asset).
I like to describe this indicator as telling me how much “oomph” is in the movement I see on the charts. Ironically, analysts normally use absolute levels (traditional 70, 30 application) to determine overbought and oversold levels in this relative strength indicator. The CCM applies Bollinger bands to the RSI (rather than to price).
The final primary indicator in the CCM is the bandwidth indicator, the heart of the confirmation model. The bandwidth indicator (BWI) measures the distance between the RSI Bollinger bands. The theory is that volatility increases (bands are expanding) as the RSI and price are trending and that volatility decreases (bands are narrowing) as the RSI and price are moving against the dominant trend.
By creating an indicator that advances as the bands widen and declines as they narrow, traders can visually determine whether movement in the assets they follow are moving with the underlying trends or against them. Indicators such as Tony Crabel’s NR-7 (narrow range, seven periods) and the standard “double inside day” formation tell traders that an expansion in volatility is due, but they do not divulge whether the expected increase in volatility will be associated with an advance or decline in asset price.
The CCM reveals whether an expansion in volatility is associated with advancing or declining prices. The BWI should not be confused with John Bollinger’s own bandwidth indicator, which is unrelated to this model.
CHART CONSTRUCTION
In price charts, I use four windows, and each window contains...