This article was written in 2007.
With
emerging markets like the Chinese and Indian economies growing at a fast pace
and recording high percentage growth year over year, the bullishness has
spilled over to the global stock markets with all major indices hitting new
highs at the end of 2006. However, it is unlikely that the world indices will
continue to scale up without any corrections. A classic example of a worldwide
market correction occurred when the Chinese stock market recorded a near 9%
drop in a single-day in Feb 2007. This together with the Yen Carry Trade triggered
a chain reaction of global stock markets melt-down. Since then, global markets had a fast recovery
with the likes of the STI index touching the 3500 points and the Dow Jones
breaking the 13000 points barrier in April 2007. The example of global markets
melt-down and fast recovery demonstrate how volatile the stock market can be.
The willingness to take a higher risk is heavily linked to the fact that people
are better educated and information is easily available with the help of the
internet. Moreover, the one factor in
the stock market that has not changed since its establishment is market
psychology. The human psychologies of fear, greed and hope remain the main culprits
of the high volatility in the stock market.
The
Bollinger Band, developed by John Bollinger, is widely used by traders to trade
the market effectively. The Bollinger Band is constructed using 3 lines; the upper
Bollinger band, the Simple Moving Average line (SMA) and the lower Bollinger
band. The upper and lower Bollinger bands are usually placed at a distance of 2
standard deviations above and below the SMA respectively. Standard deviation is
a mathematical term in which the value is proportional to the volatility of the
price movement. SMA line is the averaging of the close price over a certain
number of days. Hence, when the stock is
trading sideway or the price volatility is low, the upper and lower bands will converge
toward the SMA line. On the other hand, the upper and lower bands will begin to
widen and move away from the SMA line when there is substantial fluctuation in
the stock price. This article will look in the different ways that Bollinger
Bands are used.
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The
first application of Bollinger Band is its use in providing an indication of
support and resistance level. As we expect prices to move in between the upper
and lower bands, the upper band acts as a resistance level to more upsides
while the lower band acts as a support level to more downsides. The following shows how the upper and lower
bands provide support and resistance to the price movement.
Figure 1: Use of Bollinger
Band as Support and Resistance
During the month of January 2007 to April 2007,
FerroChina’s stock price was well-resisted by the upper band, refusing to break
new grounds. On the other hand, during the price retracements in early March
2007 and late April 2007, FerroChina was able to find good support level at the
lower band that prevented the price from diving further.
The second application of Bollinger Band is in the
powerful Bollinger Squeeze which trigger high probability buy and sell signals.
The Bollinger Squeeze occurs when a stock protracted to a period of low volatility
has the upper and lower bands appearing to be squeezed together. A buy or sell
signal is generated when there is a Bollinger breakout from this squeeze of the
lower and upper bands. Figure 2 shows the occurrence of the Bollinger Squeeze
and the subsequent Bollinger breakout when the upper and lower bands begin to
expand suddenly.
Figure 2: Bollinger Squeeze
and Subsequent Bullish Breakout
During the period of January 2007 to March 2007, the big
gap between the upper and lower bands shows that Hyflux was trading with high
volatility. However in Apr 2007, Hyflux started trading sideways and as a
result, the upper and lower bands contracted and squeezed together, indicating
the occurrence of the Bollinger Squeeze. A Bollinger breakout then happened when
both bands suddenly diverged with the price hugging the upper band thereby
triggering a bullish signal. The reverse is true for a breakout to the
downside. This is illustrated in Figure 3 where a Bollinger Squeeze was formed in
April 2007 with the subsequent bearish breakout happening on 23rd of
April 2007.
Figure 3: Bollinger Squeeze
and Subsequent Bearish Breakout
We
can further enhance the Bollinger breakout after the Bollinger Squeeze with
another indicator thus increasing the probability of making a trade in the
right direction of breakout. One popular indicator that can be used together
with the Bollinger Squeeze is the Relative Strength Index (RSI) which was
developed by J. Welles Wilder. The RSI is a powerful indicator used to measure
the velocity of the price movements and the values are calculated based on the
number of days that the price closes up and the number of days that the price
closes down over a certain period of time. In this article, the period of time
used is 14 days which is originally proposed by Wilder. Let us re-visit the
earlier chart (Figure 2) which featured Hyflux where a buy signal was generated
by Bollinger Squeeze on the 25th Apr 2007. An analysis of the RSI
indicator shows that the RSI was well supported during the Bollinger Squeeze and
was trending upwards as the price approaches Bollinger breakout. This signifies
that the price action remain firm throughout the Bollinger Squeeze and it grew
in strength as breakout came beckoning. Figure 4 shows the chart of Hyflux using
RSI indicator in conjunction with Bollinger Band.
Figure 4: Usage of
Bollinger Squeeze with the RSI indicator
The
above scenario of combining RSI and Bollinger Band in our analysis can be
easily captured by using an automated software program which could save a
significant amount of time from looking for these opportunities. One such
software is ChartNexus XPertTrader (www.chartnexus.com)
that can be used to automatically screen the whole market for stocks that have
Bollinger Squeeze together with the RSI trending higher.
This
article has highlighted the importance of understanding the volatility of the
stock market in order to make profitable trades. A powerful indicator such as
Bollinger Band is widely used to identify buy and sell signals based on two
applications. The first involves using the bands as support and resistance with
the second involving looking for a Bollinger Squeeze followed by a Bollinger
breakout.. Combining Bollinger band with the RSI indicator also increases
significantly the probability of the signal being valid.
This article first appeared in Smart Investor in 2007.
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.
