thE hAnDbook of tEchnicAL AnALySiSdivergence provides no directional information with respect to future price action,
hence it is not possible to determine if a divergent setup is bullish or bearish. Band-
width divergence tracks the volatility in the market, and therefore converging bands
represent periods of lower volatility while diverging bands represent periods of
greater volatility. Bandwidth divergence is particularly useful in predicting:
■ (^) Potential breakout moves in the market especially after an extended period of
low volatility (trades based on taking advantage of these low volatility break-
outs are popularly referred to as squeeze plays)
■ (^) Reversals at historical overbought bandwidth levels
In Figure 9.104, the reversal in the Russell 2000 Small Cap Index, indicated at
points 1 to 6, coincides fairly consistently with the test of the historical overbought
or extreme level on the Bollinger bandwidth indicator. The upper extreme level
represents periods of high volatility whereas the lower extreme reflects periods of
low volatility. Point 6 may be of particular interest to traders as it represents a
supportive confluence comprising a projected channel bottom and a prior support
level, accompanied by a Bollinger bandwidth divergence peak. Hence, point 6 rep-
resents a high probability entry. As far as trading at points 7 and 8 is concerned, as
with any divergent setup, there must be some form of price confirmation to trig-
ger an entry. Assuming that we use the 20‐day moving average (which happens to
represent the central value of the Bollinger Band) as the barrier required for price
confirmation, no trade would have been initiated at points 7 or 8 as there was no
decisive closing penetration of the moving average at either points.
Figure 9.104 Forecasting Reversals in the Russell 2000 Small Cap Index with
Bollinger Bandwidth Divergence.
Courtesy of Stockcharts.com