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Part III: Bollinger Bands on Their Own

Bollinger Bands can aid in pattern recognition by providing definitions: high and low, calm or volatile, trending or not- definitions that can be compared from time to time, from issue to issue, and from market to market. As the patterns evolve, the bands evolve right along with them, providing a relative, flexible framework rather than the absolute, rigid framework imposed by the grid of a chart or the hardness of a trend line.

Securities rarely transition from bullish phases to bearish phases or vice versa in an abrupt manner. The transitions usually involve a sequence of price action that typically includes one or more tests of support or resistance. Ms and Ws are examples of patterns that form at turning points in the markets and let us know that the prior trend has ended and a new trend has started. That new trend can be a reversal of a prior uptrend or downtrend, a transition from a trendless state, or it could be the beginning of a sideways trend such as a consolidation. Most common are double bottoms and head-and-shoulders tops. But not all reversal patterns are W bottoms or extended M tops characterized by three "pushes"; they are merely the most common (Figures 10.1 and 10.2).

Spike tops and V bottoms can and do occur, marking virtually instantaneous transitions from up to down or vice versa. Some reversal patterns dont turn out to be reversal patterns at all; they simply mark the end of the prior trend and a transition to a sideways market, rather than the beginning of a new trend in the opposite direction. Then there are longer, more complex patterns too: gradual transitions from downtrends to uptrends known as bases, congestion patterns, and complex tops.

Often patterns are small parts of larger patterns that can be seen only on a longer scale, say, by shifting from an hourly view to a daily view, or from a weekly view to a monthly view. There was a trading system2 created in the late 1980s that used three time frames and required that the patterns or signals be similar in all three time frames before a trade was taken. This was a "fractal"3 approach to the markets and one of the most eloquent demonstrations of the importance of overlapping time frames ever presented.

It turns out that fractal patterns are very common. For example, take a long-term W bottom. When examined closely, the W may turn out to have intermediate-term W bottoms



Chapter 10: Pattern Recognition

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Figure 10.1 Three pushes to a high, Pharmacia, 150 days. Three pushes to a high followed by sharp downside action that breaks the trend.

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Figure 10.2 W bottom, Bear Sterns, 100 days. Classic W bottom-note the positive candlesticks right after the lows.



Part III: Bollinger Bands on Their Own

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Figure 10.3 M within a W, Harley Davidson, 100 days. Can you see the M within the W?

embedded in its footings; and often youll see a small M formation appear at the apex of the W (Figure 10.3). There is really no limit to this fractal quality, though more than two or three levels are rarely observed at work concurrently.

Regardless of the level of magnification, technical patterns refer to a sequence of price action that forms a typical pattern on the chart with a recognizable signature-a pattern and signature that can be elucidated with Bollinger Bands. To wit:

An ideal example of a W (a double bottom) involves an initial decline followed by a recovery rally, and then a secondary decline followed in turn by the initiation of an uptrend. It isnt important whether the second decline makes a new low or not-at least in absolute terms. The first low will be outside the lower Bollinger Band, while the second low will fall inside it. Volume will be higher on the first decline than on the second (Figure 10.4).

A similar top is not necessarily a perfect mirror of the bottoms pattern; the top will likely take more time and consist of three (or more) upward thrusts to complete the pattern rather than just



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