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The Sleuth Hello again, Sleuths, In my last Sleuth column, I discussed Bollinger Bands, an indicator popular among traders and technically versed investors. I described the concept behind Bollinger Bands and how they are constructed. Today, I’d like to tell you about some implications you can draw from this technical tool and a couple of ways you can use them to augment your trading or investing efforts. In order to effectively use Bollinger Bands, it’s helpful to understand what they reflect. In my last Technical Tuesday column, I mentioned that Bollinger Bands serve two functions. First, they inform you of the current volatility level of a stock, exchange traded fund (ETF), or index. Second, the bands mark for you the current trading range of the security you have under the technical microscope. Now, it’s important to remember that Bollinger Bands do not indicate which direction a stock or index is headed. For that you can use momentum or trend indicators, moving averages, support and resistance lines, or chart patterns. When you add Bollinger Bands to your analysis, you can also make a more astute assessment of the chances of a strong move taking place and the profit potential in that move. ************************************* 100% No-Risk Gains, Averaging 43.1% per Year Over the next two years, you'll witness the greatest surge in gold prices in market history -- at least 257% above where gold sits today. So imagine if you could lock in all the gains on gold's big move... but never lose money if it backslides or falls flat. Not a nickel. Whatever you invest, you keep. But you'd still get to benefit from 100% of any move to the upside, no questions asked. Learn all about the "zero-downside" gold investment right now... ************************************* With that in mind, let’s take a look at some ways you can use Bollinger Bands to enhance your trading or investing performance. First of all, how can knowledge of a stock or index’s volatility help you? Knowledge of volatility allows you to better assess the risk and reward in a trade or investment. For example, if a stock is bouncing back and forth between its upper and lower Bollinger Bands, you can gauge how large a move to expect. Similarly, knowledge of volatility can assist you in gauging the risk of a move against you in a stock or ETF you already own. But volatility also can tell you other things. Narrow bands indicate that a stock or index is trading within a tight trading range. Think about that for a second. Now, consider that stocks and indices move from trading in trends to trading in trading ranges and back again. It is true that -- since Bollinger Bands are adaptive and change in relation to recent prices -- narrow bands reflect a stock or index that has been trading within a small range. But since stocks and indices frequently shift back and forth between trading ranges and trends, contracting Bollinger Bands can also provide you advance notice that the commencement of a new trend is imminent. How does this work? In the textbook case, the Bollinger Bands of the stock or index in a trading range will converge, or move closer together. Ideally, both of the bands will curve toward each other, forming a very tight channel. Then, suddenly the stock or index makes a strong directional move, bursting through one of the bands. So, do you then take a position in the direction of that dramatic move? Not necessarily. You see, the first move out of extremely narrow Bollinger Bands is often a false one. Often, that initial thrust outside of one of the bands will be immediately reversed. It is then that a trend frequently begins -- in the direction opposite the initial move. How do you know if that first strong move outside the narrow bands is a fake-out? You don’t. But that’s where the benefit using other technical tools -- in conjunction with Bollinger Bands -- comes in. Remember, I said earlier that Bollinger Bands do not tell you about the direction of a stock or index. If you use a moving average, support or resistance lines, or a chart pattern to help you discern the most probable direction of a stock or index, when you see severely contracting Bollinger Bands, you will have a greater degree of conviction in the move you are anticipating. Not only that, but the added confirmation provided by the contracting Bollinger Bands will have just shifted the odds of success a little further in your favor. ************************************* Stomp Wall Street's Wizards With Huge Gains -- Without Being Tied to a Computer 24/7 Even if you're leery about options investing, you won't be in just five more minutes. That's how impressive this system is, once you see for yourself how it works -- and how well it works. So for now, forget everything you THINK you know about options, and keep reading... ************************************* Now, let’s consider one other point concerning volatility. In my last Technical Tuesday column, I said it is commonly believed that when a stock or index trades up to its upper Bollinger Band, it becomes overbought -- and due to fall. And when a stock or index trades down to its lower Bollinger Band, it is oversold and set to rally. I then said that this common conception is true some of the time and not others. It is when a stock or index is in a trading range that this common belief holds true. So, if a stock or index has just entered a trading range, you could expect to see a move from one Bollinger Band to the other. Again, use one or more indicators, averages, lines, or patterns to confirm that the stock or index is in a trading range. What is particularly attractive about using Bollinger Bands with a stock or index entering a trading range is that -- since a trend will have just terminated -- the bands will still be relatively far apart. Thus, the range you are attempting to exploit is relatively wide -- with an opportunity to nail down a larger profit than at a later stage in the trading range, when the distance between the Bollinger Bands is narrower. We’ve talked about how to use Bollinger Bands when a stock or index is caught in a trading range, but what about when that stock or index is in a trend? Here’s how Bollinger Bands can help you in this situation. First, if you have entered a position near one of the Bollinger Bands prior to a big move -- i.e. you are long a stock, ETF, or call option near the lower Bollinger Band, or short a stock, ETF, or long a put option near the upper Bollinger Band -- look for a move to the centerline. If your stock or ETF continues through the centerline, use the Bollinger Band on the other side as your target. So far this sounds a lot like a trading range, doesn’t it? It’s not. You see, a stock or index trading in a strong trend can go outside the band and remain there for quite some time. For example, a strongly trending stock or index can pierce through its upper Bollinger Band and continue to trade there for a long while. Similarly, the reverse is true for a stock or index locked in a major downtrend. In other words, this is where the common conception about how to use Bollinger Bands is wrong. If you exit your position when that trending stock or index first touches that Bollinger Band you could cost yourself significant profits. One other situation that can occur in a strong trend is that a stock or index can trade all the way from one Bollinger Band to the other and then hover around that far Bollinger Band for a period of time. Here again, you don’t want to exit too soon -- on the mistaken assumption that a stock or index simply bounces between its upper and lower bands. Otherwise, you could be cutting short an opportunity to maximize a profitable position. I’d like to touch upon one last point. You can often enter a favorable position in a trend by waiting for a divergence between the price of a stock or index and the position of the Bollinger Bands. For example, if you are interested in purchasing a stock and that stock trades below its lower Bollinger Band, wait for that stock to make another low inside the lower band. It doesn’t matter whether that second low is higher or lower than the first one. What matters is that the second low -- unlike the first one -- is inside the lower band. This is considered a bullish divergence -- and a good trade setup. The converse is true when seeking to establish a short position. Wait for the stock or index to make a high inside the upper Bollinger Band -- after a prior high above that upper band -- before entering your position. As you can see, Bollinger Bands offer the astute technician some important information about the character of a stock or index. Although they can’t tell you a stock or index’s likely future direction, Bollinger Bands can provide some choice clues about the probable length of the next move or keep you from exiting a profitable position too soon. So, the next time you contemplate a new position -- or scratch your head over an old one -- before you act, remember to strike up the bands. Trade well,
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Mark Bail has spent several years studying the financial market as well as running several options, equities, and mutual fund newsletters... <click here for full bio> |
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