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Does a Bollinger Band Really Mark an Oversold Market?

Over the past few weeks there's been a swath of news that has positively impacted the equities market. Earnings reports, fed news, and BoJ interventions have led the risk-on trade higher, and the major market indexes have broken out.

This breakout, however, seems to have moved much faster than usual. In fact, we've seen a close above the 2-standard deviation Bollinger Band. I'm hearing whispers of "overbought" here once again.

But the price action is not bearish, at least right now-- and this comes from a misunderstanding about how Bollinger Bands work.

Bollinger Bands are an adaptive volatility study. It attempts to encompass the majority of price action, and if we get outside these bands, it often indicates that some mean reversion is necessary.

Misread Signals

But mean reversion does not have to happen! This is a fault of many new traders that are looking for the holy grail and don't keep indicators in context. What the bollinger bands are really good at is marking volatility cycles-- which is a cycle that many new traders miss.

After we see Bollinger Band compression, price will come out of equillibrium and we will see volatility expansion. Often times price will go outside of the Bollinger Bands, but it's because the BB lags price and was for a previous volatility period. In fact, when we see both price and volatility expansion, it often tells us that the direction of the move is sustainable.

Here's the Evidence

Woodshedder quantifies this for us with a study showing how those looking for reversion to the mean will generally be disappointed:

And once again it comes down to this: until we see actual evidence of weakness, we need to assume that the trend is going to continue.

by Steven Place

Steven Place is the founder and head trader at investingwithoptions.com/