Technical Education: The Rubber Band Theory

December 19, 2016

Pull out a rubber band.  Now pull it with all your might in one direction. 

What happens at the point where you can’t stretch it any more?  It snaps back, right?

That very same thing happens to most stocks, indexes and ETFs, too.

If a stock is pulled too far too fast eventually it will snap back to mean, especially after being stretched by excessive forces of fear and greed.

But how do we know when the “stretch” is too much?

Aside from using RSI, MACD and Williams %R as we describe here, we can also use Bollinger Bands along with Williams %R.

You can pull up just about any chart to see these two indicators in action. 

Oftentimes, they work quite well.  For our purposes, we’ve chosen to use Coca Cola (KO).

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Bollinger Bands

When it comes to Bollinger Bands (plotted at standard deviation levels above and below moving averages, such as the 20-day moving average), stock prices tend to stay within the upper and lower bands.  

When the prices move to or above the upper Bollinger Band, we have an overbought trade.  If prices move to or below the lower Bollinger Band, we have an oversold trade.  In short, Bollinger Bands let us know how far we can pull our rubber band. 

Here’s an example with Coca-Cola (KO).  Notice what happens when the lower or upper Band is hit or penetrated.  Typically, up to 80% of the time, the stock will bounce off either the upper or lower Bollinger Band.

But as with any indicator, never rely on a single indicator as a guide.

That’s a great way to lose money.  Always confirm and confirm again.

Williams % Range

We never want to rely on a single indicator, such as Bollinger Bands to make stock buying or selling decisions, so we begin to confirm with others, such as Williams % Range. 

What’s interesting about Williams is its uncanny ability to signal reversals two days before reality strikes.  Traders use the indicator to confirm. 

Let’s revisit Coke again.

When Williams reaches near zero, it’s overbought.  When it reaches to -100, it’s oversold.  Look at what happens when the KO stock hits the upper Bollinger Band, as Williams reaches toward zero, the stock reverses about 80% of the time.

Now look at what happens to KO when the lower Bollinger Band is hit, and Williams % Range dips to -100.  Again, the stock reverses about 80% of the time.

Just remember to always confirm your findings multiple times.

We’re not playing with Monopoly money on Wall Street… so be sure before you commit.

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