It can be said that to trade effectively, one has to understand that markets are filled with an extremely large number of market participants, along with their hopes, fears and thoughts - both rational and irrational. As traders, we are ultimately trading people and not stocks. It is people and their thoughts and expectations that push a stock to support and resistance. Fundamentals don't move stocks in the near term, it is people's expectations that do. A stock can have a 3% move in a day without any change in the underlying fundamentals. Money, and the thought of making or losing it, has a way of driving an otherwise rational person to incredibly irrational behavior. Your job as a trader is to capitalize on other traders' irrational behavior with a well thought out plan. We'll show you how to design and implement this plan by using Bollinger Bands®.
Making Sense of Irrational Behavior
Fear is one of the emotions that can be preyed upon by the professional trader. As a stock pulls back in a normal correction, tension builds among the holders of that stock. The further it pulls back, the more a trader is afraid of losing unrealized profits, or worse, the trader is underwater. This fear can turn into pain, and instill irrational thoughts into a holder's mind. Although the stock may be in a strong trend, the fact that a trader is losing hard-earned profits causes the trader to rethink his or her position. The trader will probably reduce his or her position several times, or sell out altogether. Sometimes, the fear spreads to other traders as the stock continues to fall, causing a group of traders to act in cohesive irrationality. While irrationality is subjective, it becomes a trader's job to identify where a group of market participants has let an otherwise healthy stock drop too far. (For more insight, see Understanding Investor Behavior.)
Why Bollinger Bands®
Because we are looking for a case where irrational behavior has caused a stock to move to a price extreme, we need an objective means for measuring fair value. A Bollinger Band® consists of a center line (moving average) combined with a band above and below the center line, measuring standard deviations of the stock's price. The bands will expand and contract depending on the volatility of the stock. The middle band is a moving average of price, which can be considered the mean price, while the upper and lower bands tend to measure price extremes.
|Chart by StockCharts.com|
Bollinger Bands® can be used as an effective means to gauge what "fair value" is simply by observing how far a stock is from its mean price. By using the thesis that a stock typically reverts to its mean price, a trader can objectively measure how far from fair value a stock is. This will help the trader determine the added risk for a particular trade.
For instance, if a trader is looking to enter a stock, but it is trading well above the upper Bollinger Band®, a trader would know that the odds favor a reversion to the middle band, and would therefore wait for the appropriate entry. While stocks can ride the upper Bollinger Band® in price extremes, at least a trader can objectively measure that extreme value and factor it into the decision making process. (To learn more about how Bollinger Bands® are constructed see, The Basics of Bollinger Bands®.)
Finding Weakness in Strong Stocks
One of the keys to this strategy of buying fear is to find a stock in a longer term uptrend. Stocks in downtrends tend to move down to the lower Bollinger Band® all the time, so looking for stocks at the lower band is not enough. Stocks in a strong uptrend tend to pull back as they consolidate the buying pressure - as it moves higher, traders tend to sell, and as it moves lower, traders tend to buy.
While there many ways to find stocks in a longer term uptrend, one way is to look for stocks in the upper 70% of their 52-week range. Another is to look for a stock with a rising long-term moving average such as a 50- or 100-day. One strategy is to combine the two in order to find stocks within 30% of a new 52-week high, and with a rising 50-day moving average.
A trader can use Bollinger Bands® combined with the screening methods above to find stocks trading at extreme lows, while still exhibiting longer-term strength. This can provide for a low-risk opportunity to enter an uptrend.
Trading in Action
Buying fear can be risky, so it is always best to wait for possible confirmation that the downtrend is over. Typically, when a stock makes its first trip to the Bollinger Band®, it bounces back to the mid-line, and then drifts back to the lower band again. While V-bottoms occur, the probabilities are for it to revisit the lower band. If you think of the psychology behind this action, a group of traders were caught in the pullback to a price extreme and, as it moved back to "fair value", some of that group will be anxious to get out at higher prices. Trader emotions typically take time to reach equilibrium.
A trader can use other technical indicators such as MACD or stochastics to measure when short-term momentum is turning. The key is to attempt to recognize when fear is starting to be overwhelmed by greed. Then a trader can employ a tight stop-loss under the recent price extreme. Keep in mind that managing your risk is very important when buying stocks that are pulling back - they don't always bounce higher. (To learn more, read When Fear And Greed Take Over.)
On strategy is to look for a candle pattern to emerge once a stock is starting to turn off the lower band. In the example below, notice how Correction Corp of America pulled back to a rising 50-day moving average and then bounced higher. The first move up was met with sellers, and then it drifted back down. A nice candle pattern emerged as it touched the 50-day moving average again and bounced higher. This was also a double bottom that allowed for an easy place to enter a stop-loss order.
|Chart by StockCharts.com|
Another wrinkle to trading Bollinger Bands® is to pay attention to how the bands contract and expand. Stock prices tend to narrow in range as they consolidate a prior trend. The Bollinger Bands® will follow suit and contract. Once a stock begins to trend again, the bands will expand, revealing the increased volatility. Powerful moves often occur after a stock's bands contract tightly. Below is an example of a trade in Crocs Inc. where the Bollinger Bands® contracted tightly, as the stock pulled back to a rising 50-day moving average.
|Chart by StockCharts.com|
|Figure 3: Bands narrowed greatly in range as it trades in a tight consolidation.|
Each of the examples above reveals where a group of traders let fear or panic drive a stock to a negative price extreme. The use of Bollinger Bands®, coupled with other techniques, can help traders identify when a stock is trading at that price extreme in a strongly trending stock. Understanding how market psychology works, and measuring it objectively, is a key tool in a professional trader's toolbox. While the methods may differ from trader to trader, the key is to have a means to identify when a group of traders may be shifting levels of supply and demand to an extreme. This is how market professionals take advantage of the uninformed trader every day. Your job as a trader is to not follow the herd, and instead, keep a clear and objective mind when examining a potential trade.