J.P. Morgan – the iconic financier of early 20th century corporate America – was once asked what he thought the stock market was going to do.
“It will fluctuate,” he responded.
Truer words have never been spoken.
Volatility is an essential characteristic of dynamic financial markets. And while academic theories like the efficient market hypothesis might aim to rationalize wild price fluctuations, volatility remains a concrete reality for the common investor.
But rest assured, this is a very good thing.
The ebb and flow of daily (and even intraday) price movements give rise to the opportunities that make earning a return possible at all.
After all, you can’t “buy low and sell high” without market lows and highs, right?
Studying a business’s financial statements to determine its intrinsic value won’t, by itself, help to explain the irrationally frequent changes in its market price.
When is a good time to enter (or exit) a position? Do current market prices reflect a fair value or irrational euphoria that will soon be corrected?
Something else must help us make sense of things.
For that reason, I often use technical analysis to see through the white noise of market fluctuations (and potentially maximize long-term performance).
There’s a sizable toolbox – available to almost all investors and traders – of technical indicators that can help us look past the short-term noise of market behavior and recognize true market trends.
Allow me to make note of just one…
Developed by analyst John Bollinger, Bollinger Bands are a unique way of setting reasonable boundaries for a stock’s price movement over time.
The method presents a high probability range for price activity based on historic performance.
Below is an example of Bollinger Bands used on AT&T’s (NYSE: T) price chart…
See those yellow lines hovering around the price? Those are the Bollinger Bands. And the blue line is a 20-day moving average.
The amount of space between each band and the moving average is based on what’s called standard deviation: a statistical measure of variation within a set of numbers.
In our case, the set of numbers being measured is the set of closing prices for the prior 20 days.
The larger the standard deviation, the more prices are spread out from their average. The smaller the standard deviation, the closer prices are to the average.
By default, Bollinger Bands are drawn at two standard deviations from the average. That means roughly 95% of close prices will fall between the upper and lower bands.
In strong trending markets, the price action will tend to cluster between one band and the moving average.
In the example above, you can see that shares of AT&T have been trading sideways for the past several months, with no clear uptrend or downtrend in sight.
When an individual stock or stock index is in an uptrend, its price action will generally occur between the upper band and the moving average line.
On the other hand, stocks or indexes that are trending downward show price action between the moving average and lower band.
Now, consider the state of the broad market…
In this chart, the S&P 500 Index has traded between its 20-day moving average and its upper Bollinger Band for almost the entirety of 2019 – a clear sign of bullish momentum.
As you can see, the rebound is proving strong and healthy following last year’s destructive market correction.
Technical analysis allows investors to trade with the dominant direction of the market instead of against it.
Simple tools like Bollinger Bands are helpful for not only identifying trends but profiting on them with confidence.
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Source: Energy & Resources Digest