Market Health

Profit With Confidence Using This Technical Indicator

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, by itself, won’t help to explain the irrationally frequent changes in its market price.

When is it a good time to enter (or exit) a position? Do current market prices reflect a fair value or an irrational euphoria that will soon be corrected?

Something else must help us make sense of things.

For that reason, many traders use technical analysis to get past 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 tune out the short-term noise of market behavior and recognize true market trends.

Let’s talk about one in particular.

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 historical performance.

Below is an example of Bollinger Bands used on Pfizer‘s (NYSE: PFE) price chart…

Bollinger Bands on Pfizer

See those yellow and green lines hovering around the price? Those are the Bollinger Bands. And the dotted 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 the 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.

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.

On the other hand, stocks or indexes that are trending downward show price action between the moving average and lower band.

In the example above, you can see that shares of Pfizer have been trading so high on vaccine news that the price is actually above the upper band. This means Pfizer’s recent movements are anything but average, and we can expect it to cool off soon to within its historical range.

Now, consider the state of the broad market…

Bollinger Bands on S&P 500

In the beginning of 2020, the S&P 500 traded between its 20-day moving average and lower band – a sign of bearishness – before plummeting in mid-March. Since then, it has mostly traded between the moving average and upper band – a clear sign of bullish momentum.

So as you can see, we’re heading into 2021 on a hot streak.

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 also profiting on them with confidence.

Good investing,

Profit Trends Research Team