Most of us are familiar with what happens when you pull a rubber band too far.
It has a tendency to snap back. That same idea applies to stocks, too. For example, if a stock sells off too much too fast, it has a tendency to snap back, or revert to mean.
Or, if a stock runs too high, too fast, it’ll often snap back as well.
While there are multiple ways to identify just how far the rubber band has been pulled with relative strength (RSI), MACD, money flow (MFI) and Williams’ %R (W%R), we can also look at Bollinger Bands and Keltner Channels.
In technical terms, when it comes to Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands. Bollinger Bands allow users to compare volatility and relative price levels over a period of time. They consist of three bands:
- A simple moving average (SMA) in the middle
- An upper band (SMA plus 2 standard deviations)
- A lower band (SMA minus 2 standard deviations)
In Plain English, they let us know how far we can pull our rubber band before it begins to pivot in the opposite direction. Look at Advanced Micro Devices (AMD), for example where I’ve set the Bollinger Bands to 2,20, or two standard deviations above and below the 20-day moving average.
Notice what happens about 80% of the time when the upper or lower Bollinger Band is touched or penetrated. It bounces. And we can confirm potential pivots here with RSI and with MACD, as well.
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We can also look at the Keltner Channel (KC).
Keltner Channels are volatility-based lines set above and below an exponential moving average (EMA). This indicator is similar to Bollinger Bands. Instead of using the standard deviation, though the KC use the Average True Range (ATR) – which looks at the degree of price volatility -- to set channel distance.
We can again look at AMD and see that the stock also stays within the parameters of the Keltner Channel, just as it does with Bollinger Bands.
Again, though, just because the KC or BB highlights a potential opportunity, it is crucial that you always confirm with other indicators.
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