Simply watching the VIX has failed traders in recent years, and technical tools like Bollinger bands and Starc bands have proven to be more effective measures of volatility and risk.
Since the Japanese earthquake and tsunami in March, market volatility has clearly increased, which has left many traders and investors scared or on the sidelines. Over the past couple years, much of the focus on volatility has been with regard to the CBOE Volatility Index (VIX), and though the VIX was a very helpful tool during the bear market, it has not been very helpful to most since the March 2009 lows, unless they’ve been trading VIX-based instruments.
Determining the level of volatility has been an important part of market analysis for many years, and gauging the current risk of either buying or selling has often been a key factor in whether or not a trade turns out profitable. For over 20 years, I have used two primary technical tools to measure both volatility and risk: Bollinger bands and Starc bands.
Both techniques were developed out of frustration with percentage bands in the early 1980’s. The percentage bands were plotted at a set percentage around a fixed moving average. The problem was that they would not adapt to changes in market behavior or volatility.
Bollinger bands, were developed by John Bollinger and generally are calculated by plotting two standard deviations above and two standard deviations below a 20-period moving average.
Bollinger bands are used by traders in many different ways, and John Bollinger himself has his own set of rules and guidelines, which can be found on his Web site, BollingerBands.com. Over the years, I have found Bollinger bands to be very helpful in identifying periods of low volatility.
I have generally focused on the distance between the two bands, or the band width. During periods of low volatility, this distance will contract, which allows us to better identify a range-bound market.
False breakouts in a trading range can often be identified through analysis of the band width, allowing us to use trading range strategies without getting whipsawed.
The silver market has been the poster child for volatile markets in 2011, but at this time last year, it was not trending.
Between March and August 2010, the iShares Silver Trust (SLV) traded in a range between $16.10 and $19.44. The blue lines on the chart above represent the Bollinger bands, and below the bar chart, I have plotted the band width indicator. In March and April, there were several instances when SLV closed above the upper Bollinger band, but there was little follow through to the upside.
On May 3, SLV closed above the Bollinger bands, and then two days later, closed below them (point 1). The May 3 highs exceeded the prior highs, while the ensuing drop took SLV below five-week support. Just six days later, SLV again closed above the Bollinger bands, point 2, as SLV made new highs for the year. Talk about choppy!
For those who bought the breakout, the next seven days were painful, as SLV dropped over 12% during that time.
The band width might have saved those looking for a trending market, as it stayed below 2.5 from March through August. During June, SLV dropped to test the recent lows in the $17.00 area and then rebounded back above the Bollinger bands (point 3), which caused the band width to narrow further.
Band width finally broke out to the upside on September 7 after SLV had closed for three consecutive days above the Bollinger bands. The band width breakout is a typical pattern that is observed when a market shifts from non-trending to trending.
NEXT: Using Starc Bands to Measure Volatility and Risk