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Covered-Calls 101

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Understanding Technical Indicators

New readers often ask what type of technical indicators we use and how we select the candidates for this section. Considering the recent slump in stock prices and the renewed concerns about future market direction, it seems appropriate to review some of the more effective methods of trend analysis. Today, we will discuss a tool that helps traders identify periods when prices are at extreme levels.

Bollinger Bands

Bollinger Bands are one of the most effective tools available to traders who utilize technical analysis but they do not, as is commonly believed, provide absolute buy and sell signals. The originator of this unique gauge; John Bollinger, designed the indicator to reflect whether prices are high or low on a relative basis and with this information, adept traders can identify entry and exit points by using other technical indicators to confirm an issue's price action. Here is an example of Bollinger Bands being used with a popular blue-chip issue.

As you can see, Bollinger Bands are similar to upper and lower envelopes that surround the stock price on a chart. They are generally plotted two standard deviations away from a simple moving average. This is the primary difference between Bollinger Bands and envelopes. Envelopes are plotted a fixed percentage above and below a moving average however Bollinger Bands adjust themselves to current market conditions because standard deviation is a measure of volatility. They widen during volatile market cycles and contract during less active periods. Occasionally, Bollinger Bands are displayed with a simple moving average line. The time period for the moving average can vary, but a 10-day moving average is commonly used by short-term traders. The standard deviation value can also be increased or decreased to suit your personal preference and many technicians lower the value to 1-1/2 standard deviations when using a 10-dma.

Despite the unique signals produced by Bollinger Bands, they do not always provide the complete picture of an asset's technical condition and in most cases, a separate indicator should be used to confirm the expected trend. The reason is, when the price touches one of the bands, it could indicate a continuation of the trend or a reversal in the other direction. Many technicians use the Relative Strength Index in conjunction with Bollinger Bands as it is an excellent gauge for identifying overbought and oversold conditions. Generally, when the price of the instrument touches the upper band, and the RSI is below 70, the trend will continue. The opposite is true for the lower band, and RSI indications above 30. Conversely, when the issue's price touches the upper band and the RSI is near 75-80, the trend may reverse itself and move in the opposite direction. A similar condition exists when the price touches the lower band and RSI is below 25-20.

Despite the limitations of Bollinger bands, it is possible to generate entry and exit signals from price action within the bands alone. A technical "top" formed outside the bands followed by a second top inside the bands constitutes a sell signal. The second top's position relative to the initial top is not critical but it must occur with the boundaries of the bands. This technique is often used to identify potential reversals, where the continuation rally achieves a nominal new high. Another unique characteristic of Bollinger Bands is that a move which originates at one boundary will generally continue all the way to the other boundary. This observation is particularly useful in projecting price targets.

Next week, we'll review the key components and processes used with another type of charting indicator. Readers who want to learn more about technical analysis in the interim should consider the book, "Technical Analysis from A to Z," by Steven B. Achelis. It is available in the OIN bookstore.

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