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Traders who use Bollinger Bands to measure a security's volatility often use a complementary indicator to help confirm possible price trends. Outside of the relative strength indicator (RSI), the most popular technical tool combined with Bollinger Bands is the stochastic oscillator.
The stochastic oscillator is a common momentum indicator used to compare the trading range of a security to its closing price over a period of time. Theoretically, a security's price remains relatively close to its recent high during a bull movement. Conversely, prices remain near a recent low during bear movements. There are actually three versions of this oscillator, full, fast and slow, and each can be used alongside Bollinger Bands.
Bollinger Bands plot three bands on a price chart to create two price channels. The security is said to be overbought if the price line is consistently near or breaches the upper price band. It may be oversold if the price line is consistently near or drops below the lower price band.
The stochastic oscillator is plotted below the price chart and is made up of two lines, each within a range of zero to 100. The first line, called %K, is a raw measure of possible momentum. Trading signals are generated when %K crosses the second line, %D, which is a moving average of %K.
An overbought position is confirmed if the stochastic lines cross above 75 and the price line is consistently near the upper Bollinger Band. At that level, prices are expected to drop soon. The opposite is also true; a price line trading near the lower Bollinger Band can be confirmed by crossing the stochastic oscillator lines below the 25 marks.
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