TECHNICAL ANALYSIS Trading on Volatility W · This, together with the Yen Carry Trade, triggered a...

The first application of the Bollinger Band is in providing anindication of support and resistance level. As we expect prices tomove in between the upper and lower bands, the upper band actsas a resistance level to more upsides while the lower band acts asa support level to more downsides. Figure 1 shows how the upperand lower bands provide support and resistance to the pricemovement.

During the months of January to April, FerroChina’s stockprice was well-resisted by the upper band, refusing to break newgrounds. On the other hand, during the price retracements inearly March and late April, FerroChina was able to find good support level at the lower band that prevented the price from diving further.

IDENTIFYING BUYS AND SELLSThe second application of the Bollinger Band is in the powerfulBollinger Squeeze, which triggers high probability buy and sellsignals. The Bollinger Squeeze occurs when a stock protracted toa period of low volatility has the upper and lower bands appearingto be squeezed together. A buy or sell signal is generated whenthere is a Bollinger breakout from this squeeze of the lower andupper bands. Figure 2 shows the occurrence of the BollingerSqueeze and the subsequent Bollinger breakout when the upperand lower bands begin to expand suddenly.

During the period of January to March, the big gap between

T E C H N I C A L A N A LY S I S

48 | SMARTINVESTOR june 2007

>MARKET INTELLIGENCE

ith emerging markets like China’s andIndia’s economies growing at a fast paceand recording high percentage growthyear on year, the bullishness has spilledover to global stock markets with allmajor indices hitting new highs at theend of last year. However, it is unlikelythat the indices will continue to scale

up without any corrections. A classic example of a worldwide market correction occurred when the Chinese stock marketrecorded a near 9 per cent drop in a single-day in February. This, together with the Yen Carry Trade, triggered a chain reac-tion of global stock markets meltdown. Since then, global mar-kets had a fast recovery with the likes of the STI index touching3,500 points and the Dow Jones breaking the 13,000 points barrierin April.

The global markets meltdown and fast recovery demonstratehow volatile the stock market can be. The willingness to take ahigher risk is heavily linked to the fact that people are better edu-cated and information is easily available with the help of theInternet. Moreover, the one factor in the stock market that hasnot changed since its establishment is market psychology – fear,greed and hope remain the main culprits of high volatility in thestock market.

USING BOLLINGER BANDSThe Bollinger Band, developed by Mr John Bollinger, is widelyused by traders to trade the market effectively. The BollingerBand is constructed using three lines – the upper Bollinger band,the Simple Moving Average line (SMA) and the lower Bollingerband. The upper and lower Bollinger bands are usually placed at adistance of two standard deviations above and below the SMArespectively. Standard deviation is a mathematical term in whichthe value is proportional to the volatility of the price movement.

SMA line is the averaging of the close price over a certain num-ber of days. Hence, when the stock is trading sideway or theprice volatility is low, the upper and lower bands will convergetoward the SMA line. On the other hand, the upper and lowerbands will begin to widen and move away from the SMA linewhen there is substantial fluctuation in the stock price.

Trading onVolatilityBy Ng Ee Hwa

W Figure 1: Use of Bollinger Band as Support and Resistance

Figure 2: Bollinger Squeeze and Subsequent Bullish Breakout

“The first application of theBollinger Band is in provid-ing an indication of supportand resistance level.”

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the upper and lower bands shows that Hyflux was trading withhigh volatility. However in April, Hyflux started trading sidewaysand as a result, the upper and lower bands contracted andsqueezed together, indicating the occurrence of the BollingerSqueeze. A Bollinger breakout then happened when both bandssuddenly diverged with the price hugging the upper band therebytriggering a bullish signal. The reverse is true for a breakout tothe downside. This is illustrated in Figure 3 where a BollingerSqueeze was formed in April, with the subsequent bearish break-out happening on April 23.

RELATIVE STRENGTH INDICATORSWe can further enhance the Bollinger breakout after the BollingerSqueeze with another indicator, thus increasing the probability ofmaking a trade in the right direction of breakout. One popularindicator that can be used together with the Bollinger Squeeze isthe Relative Strength Index (RSI) that was developed by J WellesWilder. The RSI is a powerful indicator used to measure the veloc-ity of the price movements, and the values are calculated based onthe number of days that the price closes up and the number of

days that the price closes down over a certain period. In this article, the period used is 14 days as originally proposed

by Wilder. Let us re-visit the earlier chart (Figure 2) that features

A graduate of the Royal Melbourne Institute ofTechnology, Ng Ee Hwa is a trainer forChartNexus, conducting regular courses ontechnical analysis and workshop sessions on maximising stock market returns through the use of technology.

Figure 4: Use of Bollinger Squeeze with RSI indicator

Figure 3: Bollinger Squeeze and Subsequent Bearish Breakout

Hyflux where a buy signal was generated by Bollinger Squeeze onthe April 25. An analysis of the RSI indicator shows that the RSIwas well supported during the Bollinger Squeeze and was trend-ing upwards as the price approaches the Bollinger breakout. Thissignifies that the price action remains firm throughout theBollinger Squeeze and it grew in strength as breakout came beck-

oning. Figure 4 shows the chart of Hyflux using the RSI indicatorin conjunction with the Bollinger Band.The scenario of combiningthe RSI and the Bollinger Band in our analysis can be easily cap-tured by using an automated software programme such as theChartNexus XPertTrader (www.chartnexus.com) that can beused to automatically screen the whole market for stocks thathave Bollinger Squeeze together with the RSI trending higher.

This article has highlighted the importance of understandingthe volatility of the stock market in order to make profitabletrades. A powerful indicator such as the Bollinger Band is widelyused to identify buy and sell signals based on two applications.The first involves using the bands as support and resistance withthe second involving looking for a Bollinger Squeeze followed bya Bollinger breakout. Combining the Bollinger band with the RSIindicator also significantly increases the probability of the signalbeing valid. SI

“... the one factor in thestock market that has notchanged since its establishment is marketpsychology – fear, greedand hope remain the mainculprits of high volatility inthe stock market. “

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