Monday, December 21, 2009
Technical analysis is more of an art than a science.
Drawing lines on a chart and interpreting indicators is less exact than calculating price-to-earnings ratios and cash-flow multiples. So many fundamental analysts and most stock market academics dismiss the value of technical analysis the same way they dismiss crystal ball gazing and tea leaf reading.
But they're wrong.
In the short term, investor psychology does more to move stock prices than does balance sheets or income statements. And there's no better way to measure psychology – and therefore gauge the short-term direction of stock prices – than through technical analysis.
Over the next four days, I'm going to share four of my favorite technical patterns and indicators and show you the best way to use them to decrease risk and increase your trading profits.
Let's kick things off today with Bollinger Bands... Here's a 52-week chart of the S&P 500 along with the Bollinger Bands:
The blue lines are the "upper" and "lower" Bollinger Bands.
You'll notice that almost all data points fall within these bands. In the rare event that a stock price moves outside of the bands, it nearly always reverses immediately and comes back inside. Short-term traders can make quick, counter-trend trades whenever a stock moves above or below the bands.
Stocks cycle through periods of high volatility followed by periods of low volatility. As Bollinger Bands expand and contract, they provide clues as to which part of the cycle a stock is about to enter.
Let me show you what I mean...
The green lines in the chart above mark periods of contracting volatility. The red lines indicate periods of expanding volatility.
When volatility is contracting, the stock is building up energy for its next big move. The Bollinger Bands don't tell you which direction the stock is headed, but as the bands pinch closer together, they're warning a large move is on the way.
This is the best time to be a buyer of options. Call and put options are relatively cheap because the implied volatility is so low.
As volatility expands, the stock is using up the stored energy. When the Bollinger Bands spread abnormally far apart, they're warning the stock is headed for a period of consolidation.
This is the best time to be a seller of options. Calls and puts are relatively expensive because the implied volatility is so high.
Go back and take another look at the chart. Notice how the Bollinger Bands are as tight as they've been all year. Stocks are on the verge of a major move.
A bullish trader would take advantage of the situation and buy up a bunch of cheap call options. A bearish trader would buy cheap puts. Of course, only one of them will be right and make money off of the trade.
Tomorrow, I'll show you how to determine the direction.
Best regards and good trading,