The calm before the storm - Bollinger band squeezes

About Bollinger bands

Bollinger bands are part of the moving average family. It uses three lines. The middle line is a moving average (usually 20 days) with an upper and lower line that is two standard deviation on either side of the moving average. Statistically, 95% of price action happens within the lines.

Bollinger bands measure periods of volatility. There have been numerous studies done on volatility. These studies reach one important conclusion. Markets tend to move in cycles of high volatility and low volatility. Studies have shown that a period of high volatility is often preceded by a period of low volatility.

High volatility usually signals the end of a trend. Low volatility usually signals the calm before the storm or the calm before a breakout in the share price and the beginning of a trend. Periods of high volatility are usually followed by a period of low volatility. Periods of low volatility are usually followed by a period of high volatility.

About Bollinger band squeezes

Bollinger band squeezes happen when there is low volatility. It indicates when there is a balance between buyers and sellers. I call it the calm before the storm. A Bollinger band squeeze usually indicates that the price is going to break out.

Visually, they are easy to identify. They occur when the upper and lower bands are close together. They are named the Bollinger band squeezes because visually, it looks as though the upper and lower bands are being squeezed together.

A Bollinger band squeeze indicates a period of low volatility

The problem with Bollinger band squeezes is although they indicate a breakout, they give you no clues on the direction that the breakout will be. Hence, more information is required to make money from a squeeze.

Use in conjunction with …

Bollinger bands measure volatility and to get a complete view of the chart, I recommend that you also use a price and a volume indicator as well. Using Price, volatility and volume indicators means that you are getting signals based on different aspects of the market rather than using three indicators that measure the same thing.

Determining the direction of the breakout

So you've seen a Bollinger band squeeze and you know that it means that the price will probably break out. How do you determine which direction that the break out will occur? Professor John Bollinger suggests that in determining breakout, you look at it together with the Relative Strength Index and also with a volume indicator for confirmation.

I tend to use the Bollinger band squeezes together with volume and news released by the company on profitability.

Volume

When I see high levels of volume, to me it indicates a possible new era for the stock price. It says that something is happening to the stock. At this stage, I go back to see whether the company has released any information that may impact on forward profits.

Share prices are a reflection of future profit potential. Hence, if a company comes out to say that profit if going to increase in the next year by 100%, then I know that profits are probably going to increase and hence underlying business value is going to increase and logically the share price should also break up on the upside.

Conversely, if I see high volume but the company has released new information that it expects profits to decrease in the future then decreasing profits as decrease business value and hence logically the share price should breakout downwards.

In this volume graph of BHP Billiton for June/July 2007, you can see one day where BHP Billiton's volume spiked up. I immediately knew something was happening in the stock. When I researched further I knew that it was due to record production levels that would mean a record 2006/07 profit announcement on 22 August and the stock price broke out upwards.

High spikes in volume like this are a beacon of a possible new era/trend in the stock.

RSI

The RSI is prone to many false indications, and there's nothing foolproof in its interpretation.
It is absolutely useless during a trend. For example, an up trend causes a continuously overbought indication, while a downtrend pushes it into permanent oversold mode.
On its own, the RSI's utility is questionable, but when combined with other techniques it comes into its own. It is especially useful for filtering out false signals generated by other indicators.

Fake signals

You do get fake signals when it comes to Bollinger band squeezes. It's not unusual for a Bollinger Band squeeze to occur and then an initial breakout only to reverse and take the reverse direction and continue that way. It's called the Head Fake. Keep an eye out for it and traders who do get caught out should move quickly so that it does not prove to be a costly trade.

Conclusion

It may seem strange for a fundamental analyst to be writing about Bollinger band squeezes but I do believe that both technical and fundamentals are important to any investor or trader. The market is not just about fundamentals nor is it only about technicals and by combining the two most powerful schools of thought on the market, it gives you more of a complete insight into where prices might be headed in the future.

The market does tend to over-react and under-react and by understanding this it allows value investors or traders to pick up quality businesses at the right time. Bollinger band squeezes with volume and fundamentals are one of my favourite ways to make money on the market.

About Julia Lee

Julia Lee is the Head of Fundamental Analysis for Hubb Financial Group. She regularly provides financial commentary to SKY News and ABC Lateline Business. Julia is a frequent guest speaker at ASX Investor Hour, Australian Shareholders Association and investment conferences. For more information about Hubb Financial Group, please visit www.hubb.com.au.