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Bollinger Band® – Trading On Volatility (Part I)
Education | 22 June 2012
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By ChartNexus

The recent year of 2011 was a good example of global melt-down and fast recovery, demonstrating how volatile the stock market can be. The Eurozone crisis had plagued global markets for much of 2011 with most indices hitting new lows in August when the credit rating of the US was downgraded by Standard & Poor’s. Markets were massively oversold as negative sentiments were in contagion and there was a correction which came along with the turn of the year. There were gradual signs that a consensus was reached for a Greek bailout. Traders scurried to pick out value bargains in the upturn and the bullishness had spilled over to the global stock markets with all major indices hitting two-year highs at the start of 2012.

The festive period further boosted optimism as the Dow Jones Industrial Average soared to its highest close in four years on 1 May 2012, as traders were back to their investing norm. Even the old adage, “Sell in May and go away”, did not at the very least dampen the celebrations, as the markets rebounded.

However, the Eurozone crisis was far from a full resolution and investors were simply in blissful oblivion that the world indices will continue the bull-surge. The Greek rejection of the IMF bailout fund proved the decisive blow as global markets were jolted back to reality with a sharp retracement of the Straits Times Index slumping to the 2,700 level and the Dow hitting below support levels of 12,200.

For close to two quarters this year alone, the STI has fluctuated from 2,700 to above 3,000 points, proving 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 readily available with the help of the Internet. Moreover, since its establishment, the one factor in the stock market that has not changed 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 three 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 two 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 average of the closing prices 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 towards 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. We will look at the different ways that Bollinger Bands are used over the course of a two-part series. In this first half, we will see how Bollinger Bands can be used as support and resistance as well as to generate buy and sell signals.

The first application of Bollinger Band is its use in providing an indication of support and resistance levels. As we expect prices to move in between the upper and lower bands, the upper band acts as a resistance level to upsides while the lower band acts as a support level to downsides. Figure 1 shows how the upper and lower bands provide support and resistance to price movements.

Figure 1: Use of Bollinger Bands as support and resistance

During the period of March 2012 to May 2012, OCBC’s stock price was well-resisted by the upper band, refusing to break new grounds. On the other hand, during the price retracements for the same period, OCBC was able to find good support levels at the lower band that prevented its price from nosediving further.

The second application of Bollinger Band is in the powerful Bollinger Squeeze which triggers high probability buy and sell signals. The Bollinger Squeeze occurs when a stock experiences a protracted period of low volatility. This will generate the appearance of the upper and lower bands being 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 began to expand suddenly.

Figure 2: Bollinger Squeeze and subsequent bullish breakout

During the period of late March 2011 to May 2011, the big gap between the upper and lower bands shows that STX OSV was trading with high volatility. However in June 2011, STX OSV started trading sideways and as a result, the upper and lower bands contracted and was 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.

Stay tuned for the second portion of this series which will be featured in Issue 438. In there, we will examine the Bollinger Squeeze with a subsequent bearish breakout and the enhancement of the Bollinger breakout with the use of another popular indicator with the Bollinger Squeeze.

ChartNexus is a regional company providing FREE charting software for the investment community. The company also organises investment seminars and training programmes on a regular basis, promoting the use of technical analysis. For more information, please visit www.chartnexus.com or email sgevents@chartnexus.com.

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