We have been talking about unusual volatility a lot lately, whether it be due to low volume or the headlines sending traders into a frenzy.
But there is no better tool to predict volatility than the Bollinger bands, and they should be an anchor indicator or any chart set up.
If you don’t know, the Bollinger bands read the average volatility of a stock and will expand (widen) or contract (tighten) depending on how volatile the price action on a given security is.
Using a two-standard deviation – as this is the common measure for volatility – off of the 20-day moving average (MA20), they create a channel that the stock will normally trade within.
Now if you are a short-term trader such as Kenny, you might be familiar with this indicator as a break above the Bollinger bands could be a sell trigger as the stock could be considered overbought.
This selling would then bring the price down as the stock attempts to return to its ‘normal’ or mean price.
It works the other direction as well, if a stock breaks below the bottom Bollinger band could indicate that a stock is then oversold, which would indicate a good point to buy as it is a good value considering where it normally trades at.
It’s all about the math when it comes to the bands.
There is no emotion to cloud your judgment and you can make a trade knowing that the math supports it.
But, I found a specific pattern of the Bollinger bands that – when paired with the moving average lines – is the perfect setup for finding directional volatility.
Keep reading and I will show you exactly how to take advantage of this ‘pre-volatility’ effect and I have a case study to prove it.
The wonderful thing about technical analysis is there is both an art and a science to it.
In the case of the Bollinger bands, the primary thing I want you to watch for is the distance between the upper and lower bands.
Watching the separation between the bands will start to show you how traders operate.
If the bands are spread apart – it is likely the volatility has passed and it is not the time to be placing a trade.
There is a secret hidden in the Bollinger bands that a lot of people will miss – the contractions.
When we see the Bollinger bands tighten, it tells you that there is something unusual happening in the stock or ETF only to be followed by a natural movement in the way of a volatility spike.
Traditionally you get a signal from the bands when a stock breaks above or below its natural range. If you are waiting for that signal you are a step behind.
Instead of waiting for that signal, we take a different approach – we are looking for the time that it is more likely to see one of those breaks happen…
You guessed it, we are more likely to see a break in the bands when there is a natural tightening because the stock doesn’t need to move very far to make that happen – pretty simple right?
Now there is no simple distance such as if they are $10 apart it’s time to buy, so we have to look at the distance relative to how far apart they normally are for a stock.
You might be thinking ‘But CJ, you always tell us that just one indicator isn’t enough to place a trade. How does this help me?’
Simple, this will tell you that a moment of visceral volatility is coming… now you just need a direction to play it. That is when you start adding in the 20-day and 50-day moving averages to find the direction of the trend.
If you see tight bands and a 20-day and 50-day trending lower – it’s an easy conclusion to come to that the stock or ETF is about to hit the afterburners and make a move to the downside.
This is where my recent case study on the Bollinger bands we see in the Occidental Petroleum Corporation (OXY) comes in…
I started looking into this after I finished the report from Thursday.
And I wanted to see how the stock typically performs around a contracting Bollinger band as we are seeing right now.
I found eight instances in the last five years where the Bollinger bands contracted to one of its tightest levels within the previous year and the MA20 was trending lower.
I decided to look at how the stock performed in the 30 trading days after the contraction took place as that tends to be the sweet spot for technical trading – about 24 days that is.
This is what I found:
You’ll have to forgive me for the raw data, I dressed it up a bit to make it easier to read – but this is what gets me going in the morning – the data.
As you can see on the 30th day you’re down an average of 30% – and nobody wants to see that considering that energy likes to be the golden boy of the market.
But what is more interesting is the total drawdown in the stock for the entire month…
This is represented in the far right column, even with all of the green days this stock tends to find the stock has dropped an average of 15.4% in the month following a contraction with a bearish MA20.
This is the data you should be using to hold the line even when those pesky analysts are giving the stock and upgrade.
Look for the stock to break below the MA20 and the next thing to come is a break of the bottom Bollinger Band and our short positions on OXY are going to have us laughing to the bank.
January 07 2023