thinkMoney - Fall 2018

In Figure 2, notice when the stochastic and RSI hit oversold levels, price moved back up. But both these momentum indicators can remain in overbought/oversold areas for extended time periods. So, how do you know when the trend could reverse?

TREND-REVERSAL INDICATORS

There’s no single indicator that can tell you a trend will reverse. But some have a combination of trend,

momentum, and trend-reversal characteristics. The Bollinger Bands indicator falls into that category.

Bollinger Bands. These bands can indicate a stock’s volatility. Bollinger Bands drape around prices like a channel, with an upper band and a lower band. Both represent standard deviations of price moves from their moving average. So a one-stan-dard-deviation Bollinger Band means the bands cover 68% of price bars. Bollinger Bands of two standard deviations cover 95% of price bars, and so on. When you overlay two-standard-deviation Bollinger Bands on price bars, it means if price falls outside the bands, statistically they should stay outside the bands only about 5% of the time.

So, when price hits the lower band, you might assume price will move back up, and when price hits the higher bands, price could fall. But the stock’s price might move outside of the bands (see Figure 3).

Sometimes you’ll see the bands contract or “squeeze.” When you see that happening, consider it a warning of a potential impending reversal. When price breaks out of the bands and it leads to an uptrend, prices may trade along the upper band. The opposite happens in a downtrend.

Bollinger Bands may also signal the slowing of a trend’s momentum. When a bullish trend slows down, the upper band starts to round out. But it’s what price does after the rounding out that could confirm it. If price approaches the mid-band, then moves toward the lower band, then moves along it, the trend has likely reversed.

FINDING THE RIGHT MIX

To see how this all works, suppose you
select an indicator from each category—
MACD for trend, RSI for momentum, and
Bollinger Bands for trend reversal.

From the Charts tab, pull up a chart and enter a symbol, then add RSI, MACD Two-Lines, and BollingerBands studies to your chart.

NOT BLAND, NOT SPICY

It’s easy to see how indicators work on a chart in hindsight. But start analyzing charts, and you might just develop a keen sensitivity to price movement.

The market has a life of its own. And taken together, indicators may not be the secret sauce. But they can sometimes offer just the right amount of information to help you recognize and leverage directional bias and momentum.

Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.

For more on the risks of trading and trading options, see page 37, #1– 2.

FIGURE 3: MACD, RSI, and Bollinger Bands. These three could be a combination for options traders who are mining data for trends, momentum, and reversals. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.

Overbought
Oversold
Beginning
of an
uptrend

1

23

Beginning
of a
downtrend MACD divergence
WHAT DO THE INDICATORS
REVEAL IN FIGURE 3?

1. Bollinger Bands squeeze, bullish crossover in MACD, and RSI rapidly moving into overbought territory. Maybe it’s time to think about directional trades with a bullish bias.

2. Bollinger Bands start narrowing—upward trend could change. While prices are moving higher, MACD and RSI are moving lower. Momentum is slowing. Prices move within a tight range within the Bollinger Bands, and divergence between MACD and price suggests uptrend could reverse.

3. Bollinger Bands round out, price breaks through middle band toward the lower band, and breaks through it. Notice how prices move back to the lower band. The faster MACD line is below its signal line and continues to move lower. RSI also moves lower and hits “oversold” territory. All indicators confirm a downtrend with a lot of steam. Perhaps it’s time to consider putting on directional trades with a bearish bias, such as long put verticals or short call verticals.

Stochastics
Reversal
Oversold
Overbought

FIGURE 2: FINDING MOMENTUM. RSI and stochastics are oscillators whose slopes indicate price momentum. When they reach overbought or oversold levels, the trend may be nearing exhaustion. Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.