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?
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
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
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
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.
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.
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.