VOLATILITY/RESISTANCE AND SUPPORT INDICATORS

Understanding the volatility conditions of the market will significantly contribute to trading
success because when prices are at extreme volatility they cannot sustain themselves.
These conditions generate many kinds of trades. Trades can trade a reversal of
the move, or anticipate a reversal and wait for the price to retrace and then enter a
trade. There are several good technical indicators that provide quick visualizations and
measurement of volatility. This set of indicators includes the classic Bollinger bands,
volatility envelopes, STARC (Stoller average-range channels), and Linear regression
channels.
Bollinger bands provide an easy-to-see map of whether the price is at its upper or
lower ranges. Simply stated, Bollinger bands are a statistical envelope around a preset
moving average period of 20. The bands represent 2 standard deviations from this moving
average. In other words, the price is considered to be 96 percent of the time ranging
between the two Bollinger bands. The Bollinger bands are simply a version of the 100-
year-old statistical bell curve that shows probability distributions of a sample population.
When a price is probing an upper or lower Bollinger band, the trader should consider it
an alert that the price may be getting tired and will return.
Note that this is not a prediction that the price will reverse. In fact, the price may
continue to hang on at the bands (this is called “hugging the band”) and it may also break
beyond it. But the trader using the bands can sense the potential. The shape of the bands
becomes important. If the bands are sideways, prices can bounce off the top and bottom
more easily. If they are tilted, reversals are less likely. We will also see that when used in
combination with other indicators, setups for trades start formulating.
Figure 12.12 shows a Bollinger band with the default setting. Now let’s consider
the same chart with the addition of another band (see Figure 12.13). On the second
band, the setting is 13 periods with the standard deviation of 2.618. This is called an
extreme Bollinger band. Jea Yu and Russell Lockhart in Secrets of the Underground
Trader (McGraw-Hill, 2003) use the concept of extreme Bollinger bands with great success.
The addition of this extra outside band provides an outer bounder for sensing
whether the price has reached unsustainable levels. Remember that at a 2.618 setting,
almost 99 percent of the time the price is between the upper and lower Bollinger bands.
If the trading platform does not allow for settings at 2.618, one can approximate with a
setting of 3. Its use is most effective when the price reaches an extreme Bollinger band
and then proceeds to go back under the original Bollinger band. The forces that put the
price at an extreme have changed, and the likelihood of its going back to an extreme
are much lower. It will require some new energy. In forex, we can invoke a version of
Newton’s third law: Prices stay in their pattern unless news moves them out of their pattern.
The extreme Bollinger band also can act as an area for stops, which we will explore
later on.

We can see that the addition of the extreme Bollinger band adds a depth of understanding
to the forex trader. It provides an entry condition as well. If the price moves to
an extreme Bollinger band and then moves back below the standard Bollinger band (as
shown in Figure 12.13), then the trader can look to enter a trade. In Figure 12.14 we can
see an example of the price reaching the lower extreme Bollinger band and coming back
toward the regular Bollinger band, but we see the stochastic also turned, giving extra
confidence that the price is ready to reverse (with extra confidence when the stochastic
has turned as well!).
There are other volatility indicators that use envelopes similar to Bollinger bands.
The STARC band provides another boundary where the price has a tendency to stay
between the bands. For example, the same EURUSD chart shown with the extreme
Bollinger bands can be illustrated with STARC bands (see Figure 12.15). Notice how
the STARC bands form a channel and appear to provide support and resistance.
The linear regression channel is a popular graphic tool that provides another envelope
around the prices. If available on your platform, it can be used to project a potential
support or resistance area. The channel should be drawn so it extends into the future so the trader can view the upper and lower resistance areas. In Figure 12.15, we see that the
price has probed the lower support channel, and watching carefully what it will do can
pay off for the trader looking to buy on a bounce off this pattern or looking to enter a sell
on the failure of the price to come back. Figures 12.16 and 12.17 are snapshots of how
this linear regression channel pattern worked recently on the EURUSD 15-minute chart.
In Figure 12.16, we have drawn the linear regression channel from point A to point B.
Point C is the future, and the price has not reached there yet. As stated earlier, the linear
regression channel points to a zone of support around 1.3153.
The trader does nothing but wait. Using the linear regression channel adds another
layer of confirmation. If the price is probing a linear channel, it is also very likely to be
probing support or resistance. The idea for the trader is to get as much confirmation as
possible.

The use of any envelope type of indicator serves to provide an ability to increase
confidence that a trade is worthwhile. No single one is itself sufficient.




By ABE COFNAS