Bollinger Squeeze

The Bollinger squeeze is pretty self explanatory.  When the bands “squeeze” together, it usually means that a breakout is going to occur.  If the candles start to break out above the top band, then the move will usually continue to go up.  If the candles start to break out below the lower band, then the move will usually continue to go down.  Looking at the chart above, you can see the bands squeezing together.  The price has just started to break out of the top band.  Based on this information, where do you think the price will go?

If you said up, you are correct!  This is how a typical Bollinger Squeeze works.  This strategy is designed for you to catch a move as early as possible.  Setups like these don’t occur everyday, but you can probably spot them a few times a week if you are looking at a 15 minute chart. 

So now you know what Bollinger Bands are, and you know how to use them.  There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them.  So now you can put this in your trader’s toolbox, and we can move on to the next indicator, MACD.

MACD

MACD is an acronym for Moving Average Convergence Divergence.   This tool is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish.  After all, our #1 priority in trading is being able to find a trend, because that is where the most money is made. 

With MACD charts, you will usually see three numbers that are used for its settings. The first is the number of periods that is used to calculate the faster moving average, the second is the number of periods that is used in the slower moving average, and the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

For example, if you were to see “12,26,9” as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:

1. The 12 represents the previous 12 bars of the faster moving average.
2. The 26 represents the previous 26 bars of the slower moving average.
3. The 9 represents the previous 9 bars of the difference between the two moving averages.  This is plotted by vertical lines called a histogram (The blue lines in the chart above). 

There is a common misconception when it comes to the lines of the MACD.  The two lines that are drawn are NOT moving averages of the price.  Instead, they are the moving averages of the DIFFERENCE between two moving averages. 

In our example above, the faster moving average is the moving average of the difference between the 12 and 26 period moving averages.  The slower moving average plots the average of the previous MACD line.  Once again, from our example above, this would be a 9 period moving average.  This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our “slower” moving average.  What this does is it smoothes out the original line even more, which gives us a more accurate line. 

The histogram simply plots the difference between the fast and slow moving average.  If you look at our original chart, you can see that as the two moving averages separate, the histogram gets bigger.  This is called divergence because the faster moving average is “diverging” or moving away from the slower moving average.   As the moving averages get closer to each other the histogram gets smaller.  This is called convergence because the faster moving average is “converging” or getting closer to the slower moving average.  And that, my friend, is how you get the name, Moving Average Convergence Divergence!  Whew, I need to crack my knuckles after that one.

Ok, so now you know what MACD does.  Now I’ll show you what MACD can do for YOU.

MACD Crossover

Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one.  When a new trend occurs, the fast line will react first and eventually cross the slower line.  When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, which often indicates that a new trend has formed.

From the chart above, you can see that the fast line crossed under the slow line and correctly identified a new downtrend.  Notice that when the lines crossed, the histogram temporarily disappears.  This is because the difference between the lines at the time of the cross is 0.  As the downtrend begins and the fast line diverges away from the slow line, the histogram gets bigger, which is good indication of a strong trend.

There is one drawback to MACD.  Naturally, moving averages tend to lag behind price.  After all, it's just an average of historical prices.  Since the MACD represents moving averages of other moving averages and is smoothed out by another moving average, you can imagine that there is quite a bit of lag.  However, it is still one of the most favored tools by many traders. Let's now take a look at Parabolic SAR...

Parabolic SAR

Up until now, we’ve looked at indicators that mainly focus on catching the beginning of new trends.  And although it is important to be able to identify new trends, it is equally important to be able to identify where a trend ends.  After all, what good is a well-timed entry without a well-timed exit? 

One indicator that can help us determine where a trend might be ending is the Parabolic SAR (Stop And Reversal).  A Parabolic SAR places dots, or points, on a chart that indicate potential reversals in price movement.  From the chart above, you can see that the dots shift from being below the candles during the uptrend, to above the candles when the trend reverses into a downtrend. 

Using Parabolic SAR

The nice thing about the Parabolic SAR is that it is really simple to use.  Basically, when the dots are below the candles, it is a buy signal; and when the dots are above the candles, it is a sell signal.  This is probably the easiest indicator to interpret because it assumes that the price is either going up or down.  With that said, this tool is best used in markets that are trending, and that have long rallies and downturns.  You DON’T want to use this tool in a choppy market where the price movement is sideways.

Stochastics

Stochastics is another indicator that helps us determine where a trend might be ending.  By definition, stochastics is an oscillator that measures overbought and oversold conditions in the market.  The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.

How to Apply Stochastics

Like I said earlier, stochastics tells us when the market is overbought or oversold.  Stochastics are scaled from 0 to 100.  When the stochastic lines are above 70 (the red dotted line in the chart above), then it means the market is overbought.  When the stochastic lines are below 30 (the blue dotted line), then it means that the market is oversold.  As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.

Looking at the chart above, you can see that the stochastics has been showing overbought conditions for quite some time.  Based upon this information, can you guess where the price might go?

If you said the price would drop, then you are absolutely correct!  Because the market was overbought for such a long period of time, a reversal was bound to happen. 

That is the basics of stochastics.  Many traders use stochastics in different ways, but the main purpose of the indicator is to show us where the market is overbought and oversold.  Over time, you will learn to use stochastics to fit your own personal trading style. Okay, let's move on to RSI.

Relative Strength Index (RSI)

Relative Strength Index, or RSI, is similar to stochastics in that it identifies overbought and oversold conditions in the market.  It is also scaled from 0 to 100. Typically, readings below 20 indicate oversold, while readings over 80 indicate overbought. 

Using RSI

RSI can be used just like stochastics.  From the chart above you can see that when RSI dropped below 20, it correctly identified an oversold market.  After the drop, the price quickly shot back up. 

RSI is a very popular tool because it can also be used to confirm trend formations.  If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50.  If you are looking at a possible uptrend, then make sure the RSI is above 50.  If you are looking at a possible downtrend, then make sure the RSI is below 50

In the beginning of the chart above, we can see that a possible uptrend was forming.  To avoid fakeouts, we can wait for RSI to cross above 50 to confirm our trend.  Sure enough, as RSI passes above 50, it is a good confirmation that an uptrend has actually formed. Okey dokey, we've covered a smorgasbord of indicators, let's see how we can put all of what you just learned together...

Putting It All Together

In a perfect world, we could take just one of these indicators and trade strictly by what that indicator told us.  The problem is that we DON’T live in a perfect world, and each of these indicators has imperfections.  That is why many traders combine different indicators together so that they can “screen” each other.  They might have 3 different indicators and they won’t trade unless all 3 indicators give them the same answer. 

As you continue you journey as a trader, you will discover what indicators work best for you.  I can tell you that I like using MACD, Stochastics, and RSI, but you might have a different preference.  Every trader out there has tried to find the “magic combination” of indicators that will always give them the right signals, but the truth is that there is no such thing. 

I urge you to study each indicator on it’s own until you know EXACTLY how it reacts to price movement, and then come up with your own combination that fits your trading style.  Later on in the course, I will show you a system that combines different indicators to give you an idea of how they can compliment each other.

I know this has been a very loooooooooooonnnnng lesson, and I encourage you to go back and read over anything you haven’t fully understood yet.  Sometimes it just takes a couple times of reading before you truly grasp something.  Once you understand the concepts of these indicators, go to a chart and start playing with them.  Really study how each indicator reacts to the price movement. 

When you fully understand an indicator, then it will become another tool for your trader’s toolbox.  For now you should just take a break.  Grab some coffee or get something to eat.  I know your eyes are hurting!  Let this lesson soak in, and then come back when you’re refreshed! 

Use Bollinger Bands as S&R Levels and Trade Breakouts
Learn this simple technique to trade breakouts by using bollinger bands as dynamic support and resistance levels.