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  FIGURE 12.1 An MA with a + and - 10% Envelope

  This technique is based on the principle that stock prices fluctuate around a given trend in cyclical movements of reasonably similar proportion. In other words, just as the MA serves as an important juncture point, so do certain lines drawn parallel to that MA. Looked at in this way, the MA is really the center of the trend, and the envelope consists of the points of maximum and minimum divergence from it. Just as a leash pulls an unruly dog back to its owner and then allows him to run off in the opposite direction until the leash stops him, prices act in a similar manner. The leash in this case is the two envelopes, or more if we choose to draw them.

  There is no hard-and-fast rule about the exact position at which the envelope should be constructed. That can be discovered only on a trial-and-error basis with regard to the volatility of the price being monitored and the time span of the MA. This process can be expanded, as in Figure 12.2, to include four or more envelopes (i.e., two above and two below the MA).

  FIGURE 12.2 An MA and Four Envelopes

  Each is drawn at an identical proportional distance from its predecessor. In this example, the envelopes have been plotted at 10 percent intervals. If the MA is at 100, for example, the envelopes should be plotted at 90, 110, etc. Since prices are determined by psychology, and psychology tends to move in proportion,

  Major Technical Principle Envelopes are best calculated using proportionate as opposed to point or dollar amounts.

  For example, 10 percent above and below the MA as opposed to 10 points etc.

  Chart 12.1, which features the Indian market average, the Nifty, shows that the envelope technique can be helpful from two aspects: (1) developing a “feel” for the overall trend and (2) discerning when a rally or reaction is overextended.

  CHART 12.1 The Nifty 2004–2009 and Two 10 Percent Envelopes

  The disadvantage is that there is no certainty that the envelope will prove to be the eventual turning point. This method, like all techniques that attempt to forecast the duration of a move, should be used on the basis that if the index reaches a particular envelope, there is a good probability that it will reverse course at that juncture, provided of course, that the envelope has had a reasonable record of acting as a support/resistance point in the past. The actual trading or investment decision should be determined after assessing a number of characteristics, of which envelope analysis is one ingredient. In Chart 12.1, you can see that the upper band consistently acted as a good resistance zone during the 2004–2008 bull market. However, the advance in 2009 was so strong that reaching the upper envelope really had no technical meaning whatsoever. As for the downside, there were a couple of times the price reversed at the –10 percent level, but either it never reached it, as in the 2004–2006 period, or it greatly exceeded it, as in 2008. Clearly, if this technique is to be employed with any degree of certainty, it is very important to make a careful study of the relationship between the price and a specific envelope ahead of time to establish its reliability. In this respect, Chart 12.2 shows the iShares Biotech ETF with a 10 percent envelope. The lower panel shows the data displayed in a different manner, with the MA at zero and the upper and lower envelopes being represented by the dashed horizontal lines at +10 percent and –10 percent. Note how the envelopes often serve as support and resistance areas and that the price occasionally swings from one envelope to the other, just as the oscillator swings like a pendulum from an overbought to oversold condition.

  CHART 12.2 iShares Biotech 2007–2012 and Two 10 Percent Envelopes

  Chart 12.3 goes through a similar exercise for the Brazilian Bovespa Index, but this time the envelope has been expanded to 35 percent to suit the characteristic of the market. Once again, the touching of the envelope suggests the direction of the primary trend, upper envelope touches being a bull market characteristic and vice versa. That does not mean that touching the outer band is a prerequisite for a bull market. Just as it’s possible to have winter without snow, it’s also possible to experience a primary trend where the outer envelope is not touched or penetrated. The dashed arrows show that the recrossing of the envelope is usually followed by an important decline of some kind. The early 2004 signal was an obvious exception to this rule. My suggestion is to experiment with many different combinations of MAs and envelopes because each security has its own personal characteristics. Some will work quite well for you, but never expect perfection—it doesn’t exist.

  CHART 12.3 Bovespa 1995–2009 and Two 35 Percent Envelopes

  Bollinger Bands

  The Concept

  Bollinger bands (Chart 12.4) operate in a similar way, except that the envelopes, or bands, are calculated using standard deviations.1 For those of you who, like me, are not mathematically oriented, a simple explanation is that the bands contract or expand, depending on the level of volatility. The greater the volatility, the wider the bands, and vice versa. The first requirement in plotting a Bollinger band is a time span, as with a moving average. The longer the span, the smoother, but less sensitive, are the fluctuations. Chart 12.4, featuring the NASDAQ 100 ETF, plots both bands with the standard or default time span of 20 periods and a deviation of 2.

  CHART 12.4 NASDAQ 100 2011–2012 and a Bollinger Band

  Chart 12.5 compares the difference with different smoothings. The plot in the upper window shows one of 10 days and the lower one a smoothing of 40 days. It is pretty obvious that the 40-bar span is far smoother and is plotted further away from the price action.

  CHART 12.5 NASDAQ 100 2011–2012 Comparing Bollinger Smoothing Parameters

  The second parameter for plotting a Bollinger band is the amount of deviation. In this respect, the bands in the upper window of Chart 12.6, again featuring the NASDAQ 100 ETF, are calculated with a value of 4. The lower panel takes it to the other extreme with a deviation of 1 percent. It is fairly evident from this comparison that the smaller the deviation, the tighter the band and vice versa. The tight band in the lower panel is touched so many times, it is not at all useful. Alternatively, a larger deviation factor returns a band that is rarely, if ever, touched. Think of the deviation as a parameter that corresponds with an overbought/oversold level.

  CHART 12.6 NASDAQ 100 2011–2012 Comparing Bollinger Standard Deviation Parameters

  John Bollinger, the creator of this technique, recommends a factor of 20 for the time span and 2 for the deviation. Those are the parameters used for the remainder of charts in this chapter.

  Rules for Interpretation

  Rule 1. When the bands narrow, there is a tendency for sharp price changes to follow.

  This, of course, is another way of saying that when prices trade in a narrow range and lose volatility, demand and supply are in a fine state of balance and its resolution will trigger a sharp price move. In this context, a narrowing of the bands is always relative to the recent past. That’s where Bollinger bands can help visually by showing the narrowing process. They also give us some indication of when a breakout might materialize because the bands start to diverge once the price begins to take off. Two examples are shown in Chart 12.7, where it is also possible to construct some trendlines marking the breakout points.

  CHART 12.7 Oneok 2000–2001 and Bollinger Bands

  Rule 2. If the price exceeds a band, the trend is expected to continue.

  This is really another way of saying that if the price moves above the band, upside momentum is strong enough to support higher ultimate prices, and vice versa. This is a common experience at the start of a bull market and vice versa for a downward penetration. After both breakouts in Chart 12.7, we see the price immediately move outside the band. The re-crossover of the Bollinger band usually indicates short-term exhaustion, and it quickly pulls back again. However, this is just a process of pausing for breath until the trend is then able to extend again. By now, you will have noticed that the price often crosses the band several times before the trend reverses. The obvious question at this point is: How do you know when it
has been crossed for the last time? In other words, how do you know how to spot the bottom and top of a move? The answer lies in the next rule.

  Rule 3. When the price traces out a reversal formation after it has crossed outside a band, expect a trend reversal.

  In Chart 12.8, featuring the New York Stock Exchange (NYSE) Composite, we see a series of three rallies that touch or exceed the upper band (range A). The first two show no sign of exhaustion. However, after the final attempt, the up trendline is violated. Then the price falls below the previous minor low to complete a small top at point F.

  CHART 12.8 NYSE Composite Intraday Chart and Bollinger Bands

  Later, the price touches the outer band again just prior to the trading range at B, but there is no signal since it manages to hold above the lower portion of the trading range. Finally, a nice up trendline is violated and a sell signal is triggered at point E, following a temporary penetration of the outer band. What we are seeing is a series of overstretched readings, which is what a price touching the band really is. It finally confirms the overbought reading. If there is no signal, the implication is that following a brief correction, the price will then go on to register a new high or low for the move, depending on its direction. That is not always the case because there is no such word as always when working with technical indicators. For instance, Chart 12.9, also featuring the NYSE Composite, shows where the price crosses below the upper band (point A), yet it does not go on to make a new high until a worthwhile decline has taken place. In such instances, the best place to liquidate a long position is when the price crosses below the moving average.

  CHART 12.9 NYSE Composite Intraday Chart and Bollinger Bands

  Later on, at point B, you can see a small double top as the price tries for a second time to break above the band. At the next attempt (point C), there is no signal, but after the subsequent penetration, a trendline is violated (point D). Then we see a series of lows (range E). But this support was not broken, so there was no reason to sell. Finally, the price tries to break out from the trading range, but is held back by the upper band (point F). A subsequent trendline break (point G) is the signal to liquidate. In retrospect, what we see is a failed breakout, which just adds to the bearishness, once the series of lows is penetrated on the downside.

  Sometimes it is possible to combine Bollinger band analysis with the Know Sure Thing (KST). This indicator is discussed at length in Chapter 15; for now, just think of it as a smoothed momentum indicator that triggers buy and sell momentum indications when it crosses above or below its moving average. In Chart 12.10 featuring Vijaya Bank, an Indian stock, the bands narrow in the late October period as the price experiences a sideways correction.

  CHART 12.10 Vijaya Bank 2006–2007 and Bollinger Bands

  The question is: Which way will the price break? A vital clue can sometimes be gleaned by looking at an oscillator. In this chart, I am using the KST, but it could easily be the moving-average convergence divergence (MACD), stochastic, relative strength indicator (RSI), and so forth. The idea is that the KST is already declining and therefore telling us that short-term momentum is trending down. Since the price soon confirms the violation of the dashed trendline, it is not surprising that the narrowing bands, i.e., finely balanced supply/demand situations, are resolved in a negative way. Later on at point B, we see a similar setup with the narrowing bands. This time, the KST falls below its MA at around the same time that the trendline is violated.

  Summary

  1. Envelopes are moving averages that are plotted at equidistant levels above and below a specific moving average.

  2. They provide useful support/resistance points that often halt rallies and reactions.

  3. Occasionally, it is a good idea to plot several series of envelopes around the moving average.

  4. Bollinger bands are a form of envelope that is constructed from standard deviations. These expand and narrow, depending on pricing volatility.

  5. When Bollinger bands narrow, the subsequent widening of the bands is often followed by a sharp price move.

  6. When the price breaks through one of the bands, this is a sign of strong momentum and we should expect the trend to continue.

  7. When the price returns through the band, expect a pause in the trend, unless this crossover is associated with a trendline break, in which case the crossover probably represents exhaustion.

  1John Bollinger, Bollinger Capital Management, P.O. Box 3358, Manhattan Beach, CA (www.bollingerbands.com)

  13 MOMENTUM I: BASIC PRINCIPLES

  The methods of trend determination considered so far have been concerned with analysis of the movement of the price itself through trendlines, price patterns, and moving-average (MA) analysis. These techniques are extremely useful, but they identify a change in trend only after it has taken place. The use of momentum indicators can warn of latent strengths or weaknesses in the indicator or price being monitored, often well ahead of the final turning point.

  This chapter will examine the general principles of momentum interpretation that apply in some degree or another to all such oscillator type indicators. Rate of change will be used as a case study. The subsequent two chapters will discuss other specific momentum indicators.

  Introduction

  The concept of upside momentum is illustrated in the following example. When a ball is thrown into the air, it begins its trajectory at a very fast pace; i.e., it possesses strong momentum. The speed at which the ball rises gradually diminishes, until it finally comes to a temporary standstill. The force of gravity then causes it to reverse course. This slowing-down process, known as a loss of upward momentum, is a phenomenon that is also experienced in financial markets. The flight of a ball can be equated to a market price. The price’s rate of advance begins to slow down noticeably before the ultimate peak in prices is reached.

  On the other hand, if a ball is thrown inside a room and hits the ceiling while its momentum is still rising, the ball and the momentum will reverse at the same time. Unfortunately, momentum indicators in the marketplace are not dissimilar. This is because there are occasions on which momentum and price peak simultaneously, either because a ceiling of selling resistance is met or because buying power is temporarily exhausted. Under such conditions, the level of momentum is often as helpful as its direction in assessing the quality of a price trend.

  Major Technical Principle The use of momentum indicators can warn of latent strengths or weaknesses in the indicator or price being monitored, often well ahead of the final turning point.

  The idea of downward momentum may be better understood by comparing it to a car that is pushed over the top of a hill. The car begins to roll downhill and, as the gradient of the hill steepens, to accelerate; at the bottom, it reaches maximum velocity. Although its speed then begins to decrease, the car continues to travel, but finally it comes to a halt. Market prices act in a similar fashion: The rate of decline (or loss of momentum) often slows ahead of the final low. This is not always the case, however, since momentum and price sometimes (as at peaks) turn together as prices meet a major level of support (resistance). Nevertheless, momentum leads price often enough to warn of a potential trend reversal in the indicator or market average that is being monitored.

  Momentum is a generic term. Just as “fruit” describes apples, oranges, grapes, etc., so “momentum” embraces many different indicators. Examples include rate of change (ROC), the relative strength indicator (RSI), moving-average convergence divergence (MACD), breadth oscillators, and diffusion indexes.

  There are essentially two broad ways of looking at momentum. The first uses price data for an individual series, such as a currency, commodity, stock, or market average, and manipulates it in a statistical form that is plotted as an oscillator. We will call this price momentum (although volume can be manipulated in the same way). The second is also plotted as an oscillator, but is based on statistical manipulation of a number of market components, such as the percentage of New York Stock Excha
nge (NYSE) stocks above a 30-week MA. This measure is referred to as breadth momentum and is discussed in Chapter 27. Price momentum can be constructed for any price series, but breadth momentum can be calculated only for a series that can be broken down into various components.

  Major Technical Principle The principles or characteristics of momentum interpretation are the same for all indicators, but some are specially constructed to bring out a particular characteristic.

  This chapter outlines the eight basic principles. (For further study please refer to The Definitive Guide to Market Momentum, Martin J. Pring, 2009, Traders Press or the momentum module at the online technical analysis course at Pring.com.) We will be using ROC as an example, but you should remember that it is only one type of price momentum indicator. Chapters 14, 15, 26, and 27 will discuss other individual indicators for price and breadth momentum, respectively.

  It should be noted that the type of trend reversal signaled by a momentum indicator depends upon the time span over which it has been calculated. It is accepted practice to use daily data for identifying short-term trends, weekly data for intermediate trends, and monthly data for primary trends.

  It is very important to note that the use of momentum indicators assumes that markets or stocks are experiencing a normal cyclic rhythm, which is expressed in price action by rallies and reactions. However, in some instances, countercyclical reactions are almost nonexistent. Price movement is then reflected as a linear uptrend or downtrend. This is an unusual phenomenon, and when it develops, momentum indicators fail to work.