Bollinger Bands are one of the most widely used indicator of all the indicators. While it can be a great measure of price volatility using standard deviations and moving averages in its computation, there is one phenomenon that exists about the bands that can possibly be the most accurate for future trend direction: the Bollinger Squeeze.
The theory behind this technique is that when a market is compressed, we can expect to see an explosion. When price volatility is high, the bands are usually far apart. Likewise, when volatility is low, the spread between the bands is close. However, when the bands get so close and remain close for a long period of time, we can assume prices are ready for an explosion. This is what the Bollinger squeeze lets us to witness. But there is one requirement for a prospect to qualify under the squeeze: an asset's volatility must quiet. This is what produces the compression/squeeze effect of the bands.
John Bollinger (the developer of the bands) himself suggests using the Bollinger squeeze with another indicator, in particular the relative strength index. Through this, you want to identify positive divergence. We at AccuInvestor like to use the Money Flow Index because not only can we use it for divergences, but it also has a correlation with volume, since the MFI measures money flowing into a security.
For a bullish sign, look for positive divergence with the RSI or MFI (or another indicator of your choice) - that is when your indicator is heading upwards and the price is heading downwards or remaining farily the same. If you notice a volume increase as well (this is why we prefer the MFI), this is another bullish signal. When a trend is about to turn bullish, volatility may increase so high that it will cause the lower band to turn downward. Look for this as well.
For a bearish signal, look for negative divergence (price is increasing along with the indicator) along with ERRATIC and irrational volume spikes when prices are low. Another bearish sign is when before a trend change occurs, since volatitily may increase so much, the upperband will turn upward followed by a decline in price.
As you can see, Corn had very low volatility till about September. We can see negative divergence from the RSI indicator (price level wasn't going up, but it was fairly consistent. Hence, negative). The price also broke above the upper band and its resistance line in mid-September to explode upward.
NOTE: Bollinger suggests using stop losses (click here for our formula to calculate precise exits) with the Bollinger squeeze. The reason being is that the trend may create a "Head Fake" as he labled it. This is when after a break, the price moves in one direction, to suddenly turn and go in its opposite, true direction. In case you are to quick to buy, stop losses are highly recommended.
