Moving bands that channel price action are popular technical tools. Bollinger bands are very common. These variable channels display extreme price action and volatility that is likely to correct in the near future.

Flowing price channels are constructed with a baseline of a particular period's moving average. This forms the middle or "fair value" line between the bands.

Upper and lower bands follow the moving average flowing narrow and wide as market action occurs. These values are known as standard deviations of the selected moving-average line. A popular default setting for Bollinger bands is 20(2), meaning the baseline moving average is 20 time-periods of the selected chart. The upper and lower bands are two-times current market's volatility away from the mean.

The theory is extreme or volatile price action will soon return to normal much like stretching a rubber band before it snaps back to shape. Like a rubber band, the further short- term price action moves away from its baseline the more sharp and dramatic its return might be.

Price levels above the moving average line indicate strength in the underlying while prices below suggest weakness. A move from one side of the moving average line to the other may indicate a change or reversal in sentiment and strength.

Likewise, prices moving along upper or lower extreme bands can be a sign of a continued move in that direction. Release from the band and a move back towards the centerline could result in a near-term price reversal.

Using this tool to identify unusual volatility and extreme price action can help indicate market corrections. Very useful information for traders to have as our following examples demonstrate:

(hourly chart, RMBS )

Rambus reaches both extremes in this hourly chart. Notice how candles penetrate the upper and lower bands shortly before price action begins to move towards the middle line

Charting this behavior together with other studies of support, resistance and volume confirmation combines for a powerful forecasting tool.

(hourly chart, PDLI)

If we did nothing more than buy as prices met the lower band and sell once they reach the upper it might be profitable, but using Bollinger Bands in combination with other tools is the safe & prudent method for entering and exiting trades.

(daily chart, MSFT )

A look at long-term charts allows a trader to determine whether a particular stock or index is currently exhibiting strength or weakness. One conservative method is to buy only when price action trades at or above the center-line and avoid the issue while prices trade below it.

(daily chart, Dow)

Bollinger band price action can guide us to key turning points in broad markets as well. At least six different periods over six months have signaled impressive rallies in the Dow. Traders content to enter bullish trades only during these periods might very well increase their accounts many times over.

As explained, using Bollinger bands to identify extreme price action or volatility can position a trader to take advantage of near-term movement in a targeted stock.