Chapter 1: Introduction

It is not the purpose of this book to plumb the depths of the arguments, pro or con, regarding these matters. Rather, we accept the weight of the evidence that prices are not distributed normally and markets are not the simple systems that most people think they are. Our base assumption is that the markets are systems of increasing complexity that are ever harder to master.

The old saw suggests that in order to make money in the market, you must buy low and sell high-or vice versa. As the markets have become more volatile and the patterns more complex, this has become increasingly harder to do. There is a fable from the trading pits in Chicago where the most active of the worlds futures contracts are traded. It suggests there is a god who rules the pits. This god has but two rules: One, you may buy the bottom tick-once in your life. Two, you may sell the top tick-again, once in your life. Of course, by implication you are free to do the opposite as often as you would like.

The purpose of this book is to help you avoid many of the common traps investors get caught in, including the buy-low trap where the investor buys only to watch the stock continue downward, or the sell-high trap, where the investor sells only to watch the stock continue upward. Here, the traditional, emotional approach to the markets is replaced with a relative framework within which prices can be evaluated in a rigorous manner leading to a series of rational investment decisions without reference to absolute truths. We may buy low, or sell high, but if we do so, we will do so only in a relative sense. References to absolutes will be minimized. The definition of high will be set as the upper trading band. The definition of low will be set as the lower trading band. In addition, there will be a number of suggestions to help you tune this framework to your individual preferences and adjust it to reflect your personal risk-reward criteria.

Part I starts with this chapter, the introduction. Then, in Chapter 2, youll read about the raw materials available to the analyst. Next in Chapter 3, youll learn how to select the proper time frames for your analysis and how to choose the correct length and width for Bollinger Bands. In a more philosophical vein, Chapter 4 looks at the contrasting approaches of continuous advice versus the process of locating setups that offer superior risk-reward opportunities. Part I concludes with a discourse,

Part I: In the Beginning

in Chapter 5, on how to deploy successfully the ideas you will read about in this book.

Part II covers the technical details of Bollinger Bands. It begins with Chapter 6, on the history of trading bands (and in Chapter 20 in Part IV we reprise the oldest trading system known to us based on trading bands). Chapter 7, which describes the construction of Bollinger Bands, follows next. Chapter 8 is devoted to a discussion of the indicators that are derived from Bollinger Bands: %b, a method of mathematically determining whether we are high or low, and BandWidth, a measure of volatility. We close Part II with Chapter 9, which discusses volatility cycles, surveys some of the academic ideas that support the concept of Bollinger Bands, and reviews the relevant statistical issues.

If you are not interested in knowing the details behind the tools, you may want to skip Part II and go straight to Part III, where the discussion of how to use Bollinger Bands begins. While Parts III and IV build on the foundation laid out in the first two parts, you can read them independently.

Part III explains the basic use of Bollinger Bands. It starts with Chapters 10 and 11 on pattern recognition and introduces Arthur Merrills M and W pattern categorization. Then Chapters 12 and 13 tackle the use of Bollinger Bands to clarify the most common trading patterns, with W bottoms covered in Chapter 12, and M tops explored in Chapter 13. The trickiest phase, "walking the bands," is taken up next, in Chapter 14. Finally there are two related chapters on volatility. Chapter 15 describes The Squeeze-with some examples for the stock and bond markets. Then Chapter 16 provides the first of three simple methods that illustrate the rigorous use of Bollinger Bands, a volatility-breakout system rooted in The Squeeze.

Part IV adds indicators to the analytical mix. It focuses on coupling bands and indicators in a rational decision-making framework. Chapter 17 offers a general discussion of coupling indicators and bands. Chapter 18 follows with a discussion of volume indicators, including those that are best suited for use with Bollinger Bands. In Chapter 19 and 20, we focus on combining price action and indicators in two rational decision systems using %b and volume oscillators-one system that follows trends and one that picks highs and lows.

Part V focuses on a couple of advanced topics, such as normalizing indicators with Bollinger Bands (Chapter 21) and

Chapter 1: Introduction

techniques for day traders (Chapter 22), who are making increasing use of Bollinger Bands.

In Part VI, we summarize the major issues regarding Bollinger Bands via a list of rules and offer some closing thoughts.

Endnotes follow Part VI. Where I have had tangential thoughts that were important but that might interrupt the flow of the chapter, they have been included in the Endnotes. There is much of value in those notes and so be sure to check them out. The Endnotes also include references for material cited in the chapters.

The three trading methods presented in Parts III and IV are anticipatory in nature. Method I uses low volatility to anticipate high volatility. Method II uses confirmed strength to anticipate the beginning of an uptrend or confirmed weakness to anticipate the beginning of a downtrend. Method III anticipates reversals in two ways: by looking for weakening indicator readings accompanying a series of upper band tags or by looking for strengthening indicator readings accompanying a series of lower band tags. More dramatically, Method III also looks for nonconfirmed Bollinger Band tags, a tag of the lower band accompanied by a positive volume indicator or a tag of the upper band accompanying a negative volume indicator.

And now we turn our attention to jargon-you cant live with it and you cant live without it. Many years ago a new hotshot executive type at the Financial News Network, who came from radio and knew nothing of finance, declared that upon each and every use of jargon the presenter had to stop and define the term. He had a point. The terminology we used needed to be defined upon occasion, but not compulsively enough to halt the flow of content. A book allows for a convenient place where jargon can be slain, a Glossary. A lot of work went into keeping the use of jargon to a minimum and into the Glossary, so if you stumble across an unfamiliar term that is undefined in the text, or an unexpected usage, just turn to the Glossary and youll most likely find the definition. The Glossary serves another purpose too. In many cases investing terminology is poorly defined. Terms may have more than one sense or multiple meanings, all of which can be confusing. In the Glossary the sense of the terms as used here is laid out.

The book closes with a Bibliography-really more of a suggested reading list that is closely coupled to the subject matter