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Tickers in this Article: VRTX, JNJ, HGSI
Bollinger Bands®, one of the most popular indicators in technical analysis, consist of three lines. The first line, or center line, is a moving average, very often a 21-period exponential moving average (EMA). The two other bands, or upper and lower bands, are standard deviations of the center line. For example, the most common parameters of a Bollinger Band® setup are made up of a 21-period EMA, with bands at plus (+) and minus (-) two standard deviations away.

Standard deviation is a statistical measure of volatility. Empirically speaking, 95% of all data within a set will exist between ±2 standard deviations of the mean (or average). Technical analysts use Bollinger Bands® to determine where a stock is trading in relation to historical prices. If a stock is trading at the high or low range of the four standard deviation window, it can be reasonably assumed that the price will soon reverse because it will only go above or below two standard deviations 5% of the time. You can see by the example below that the majority of the time, prices will stay within the upper and lower bands.

In periods of high volatility, the bands will widen, and the stock may trade above or below the upper or lower bands. This is a sign that the stock has moved very far in a short period of time. Many technical analysts will look at this as a point of capitulation, and may prepare to enter a position awaiting a reversal. It is important to note, however, that this may not happen right away, and it would be prudent to look for other indicators as well.

Let's take a look at a company that has experienced a large run-up in price over the past week and is now trading above its upper Bollinger Bands®.

Vertex Pharmaceuticals Incorporated (Nasdaq:VRTX), a company engaged in the discovery, development, and commercialization of small molecule drugs, has seen a volatile year, with a 52-week range of more than $20. For a stock currently trading under $30, this is a very wide spread. In part, this volatility comes from Vertex's phase III trial drug Telaprevir, which it is developing with Johnson & Johnson (NYSE:JNJ) as a treatment for Hepatitis C. The competition in this area is fierce, with Human Genome Sciences (Nasdaq:HGSI) just passing its phase III and moving to get approval from the FDA. The slightest hiccup in the process of development could be enough to halt the process and give way to one of the many competitors looking to get their Hep C drug out first. (To learn more about trading in this volatile sector, be sure to read The Ups And Downs Of Biotechnology.)

As you can see in the chart below, Vertex has tried to break above and below the resistance and support set by the Bollinger Bands® before. In the two-and-a-half month period of October to present, the stock has been range-bound, with volatility increasing drastically, as can be seen by the widening of the bands. The stock managed to close above its upper band yesterday, at $29.16, indicating that the price closed high in relation to previous days. Because this stock has a history of tagging (or coming close to) its bands and reversing, traders may wish to enter a short position at this overbought level. Volume has been decreasing; the Relative Strength Index (RSI) has been increasing to historically overbought levels, and so the Bollinger Bands® signal is supported. Previously, the price has only ridden the band upward and not reversed when volume spiked and the RSI was around the 50 level - leaving room to increase before becoming technically overbought. Traders should protect themselves from a continued upward trend with a stop-loss above yesterday's high of $29.16.

A Word Of Warning
As you can see in the chart above, from mid-September until the beginning of October, the price continued to trend upward with the upper Bollinger Band® instead of bouncing down off of resistance. Just because the price of a stock is touching a Bollinger Band®, this is no guarantee of a reversal in the short term. Traders should wait for confirmation of the signal by other indicators such as the RSI.

To learn more about this valuable technical analysis tool, be sure to check out The Basics Of Bollinger Bands® and Using Bollinger Band® "Bands" To Gauge Trends.

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