In the last article we had looked at some of the different ways of
using moving averages. One of the ways is to use multiple averages to
form price bands. These are known as Moving average bands. There are
different ways of constructing such bands. We can use a displacement of
the average value by a certain percentage up and down or we can use
different inputs for arriving at the average or we could use standard
deviation as a band input.
The commonest form of MA bands is
the percentage bands. In this, one adds a certain percentage of the
average value (say 5%) to the average itself and this will give a
higher number which is plotted. Similarly, one would subtract the same
percentage from the average to get a lower number that would also be
plotted. Thus we would get two average plots each of which is
“displaced” from the original value by 5%. (We have discussed forward
displacement of the averages in earlier articles. This is a vertical
displacement of the averages). The bands are then kept as support and
resistance levels and trading rules are built around them
See
the chart above. It shows a 20 period average which is displaced by 15%
on both sides. The moving average plot is not shown on the chart above,
only the displaced bands.
The usage is quite simple. One sells
when the prices approach the higher band and buys when the prices
approach the lower band. The number of signals that one gets will be a
function of the length of the average as well as the percentage of
displacement. If frequent signals were desired then one would have to
reduce the percentage of displacement and construct additional rules.
Filters may be added as and where relevant.
Following is case
where the displacement is kept to a minimum so that the bands act as
support or resistance bands on only one side, not both. See in this
chart of Hero Honda, the 15 period m.a. has been displaced by 3% and it
functions well as a support for declines. This same band may or may not
fit the prices when the up trend changes to a downtrend. One has to
experiment. (WHAT IS M.A.?).
HiLo Moving Average Band
Jake
Bernstein first advocated the HiLo band and it is a useful tool to be
used in all kinds of time frames. What Bernstein attempted to do here
was to remove the limitations of the other band techniques that would
limit the price move. Thus, the HiLo MA band is a trend following
technique as compared to the other band techniques where we have sell
strength and buy weakness kind of approach. Of course, most traders use
this strategy of selling strength and buying weakness and to that
extent; the percentage band technique that was discussed earlier would
probably suit them better. But it should be realised that such a
strategy is against the trend and therefore is a limiting one. Big
money is made by following the trend and allowing profits to pile up.
In
the HiLo MA band, one overlays a moving average using the High of the
time period and another average using the Low of the time period as the
input. This is thus, a two average system. But the rules are slightly
different. The MA of highs and lows can never meet. Hence there can
never be an average over average crossover as in other two average
systems. Therefore, the two averages here function as a support or
resistance band only. Why is that? Because, prices can penetrate the
averages as they move up and down. In the following chart,
the
Red line is the MA of the high while the blue line is the MA of the
low. Note how during the declines the band has proved its worth,
holding back almost all the rallies. It can be noted that it is the
interplay of prices with the band that will produce the signals. In the
case of the HiLo band the signals are:
| Sell when the prices close below the lower band and buy when the prices close above the upper band. |
Additional buy or sell signals are taken when the
prices, after the first trade signal, either rally or react near the
upper or lower bands without breaking them. It will be seen that there
are multiple signals of this nature. This makes the technique a most
ideal one for the day trader. Using this technique on intra day charts
is most beneficial. |
| Once a trade is taken, the signal of the other side would act as the stop loss. |
Note
that one can also displace the moving averages in time as had been done
with the case of a single average earlier. Sometimes, this does produce
good signals.
The HiLo band, it can be seen, helps one to
track the move safely from a distance. Since the signals are clearly
defined, the system can even be automated in stocks where liquidity is
good.
The Bollinger Band
Introduced
by another leading technical analyst, John Bollinger, this technique
seeks to combine moving averages with volatility, using standard
deviation as a price band technique. Essentially, the bands seek to
limit price movements between two levels –as in the percentage bands.
The method of applying the standard deviation as a measure to come up
with the bands is logically sound.
Standard deviation is a
statistical function that identifies the volatility. Once we estimate
the standard deviation (SD), the logic is that about 66% of the data
points will lie within one SD of the mean while about 98% of the data
points will lie within two SDs of the mean. Hence Bollinger applied
this statistical observation to stock prices and created a band using
two standard deviations of the moving average of the closing price and
constructed a band around prices. Such a band can be expected to hold
almost all the price fluctuations. Hence one can use a sell rallies-buy
dips method with the band levels defining the extent of rallies and
dips. The rules are quite simple. Exit longs when prices reach the top
band and enters long when prices near the lower band.
Note
in the chart above that the bands hold almost all the moves of the
stock. It can also be noted that in strong up trend, the prices hug one
of the bands (in this case the upper band – see left portion of the
chart) while the non-trended phases of the trend tend to move within
the full range of the band. By noting this character, we can come to
know if the stock is trended or non-trended.
Since the
Bollinger bands are based on volatility, the bands will narrow and
widen as the volatility exhibited by the stock increases or decreases.
Narrowing of the bands is often a signal of a bigger move to come.
Markets always move from areas of low volatility to areas of high
volatility. Note that on the right corner of the chart, the bands are
narrowing and therefore some trended move may soon be expected in this
stock. |