Gain an Edge with Volatility Analysis

06/02/2011 4:20 pm EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

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.

chart
Click to Enlarge

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

|pagebreak|

The Starc bands were developed in the mid-1980’s by the late Manning Stoller. Starc stands for the Stoller Average Range Channel, and by far, these are my favorite banding, or channel techniques. The same formula is used on all markets and for any time frame. It goes as follows:

Starc+ = 6-period moving average + (2 x 15-period Average True Range) (ATR)

Starc- = 6-period moving average – (2 x 15-period Average True Range) (ATR)

If your software does not have the Starc bands, or if you can’t find it online, it can be created in a spreadsheet, and this link may help you with the ATR calculation. Starc bands are available on many forex trading platforms as well.

Some internet postings claim that Starc bands are similar to Bollinger bands, but this is not the case. The beauty of the Starc bands is that they are one of the few indictors than can give you an objective reading on whether it is a high- or low-risk time to buy or sell.

Using two times the Average True Range (ATR), Manning estimated that 90% of the price activity should stay within the bands. His research also determined that by using three times the ATR, close to 100% of the price activity should stay within the bands.

As for interpretation, if prices are near the Starc+ bands, it is a high-risk time to buy and a low-risk time to sell. Conversely, when prices are near the Starc- band, it is a low-risk time to buy and a high-risk time to sell.

Regular readers of my analysis know that I frequently refer to the Starc bands. In this May 20 column, I noted that two of my favorite sectors, the Select Sector SPDR - Consumer Staples (XLP) and the Select Sector SPDR - Health Care (XLV) were reaching their weekly Starc+ bands and concluded that it was a high-risk time to buy. Both ETFs made their highs that week and have since traded lower.

chart
Click to Enlarge

The May-through-September trading in SLV is a good example of how the Starc bands can be helpful tools and also illustrates some of the differences between these two indicators.

In early May, SLV closed below the Starc- bands (point 1), but instead of a continuation signal, it identified that this was a high-risk time to sell. Five days later, SLV had rallied $2.60 and formed a doji above the Starc+ band. By looking at the Starc bands, as well as the doji (a sign of indecision), traders might have avoided jumping in on the long side at that time.

Short-term doji trading rules would have you selling on a break of the doji lows ($19.11) with a stop above the day’s highs ($19.44). In hindsight, this would have worked quite well, as seven days later, SLV hit a low of $17.05 and was back to the Starc- band (point 3).

The Starc bands identified several additional range trade opportunities throughout the summer (points 4, 5, 6, and 7), as the upper and lower Starc bands were tested.

These bands are also helpful in trending markets, though SLV is not the best example. In late August, SLV tested the Starc+ bands on three consecutive days (circle a), and while there was not much of a pullback, the ranges in SLV did narrow, allowing for the use of a tighter stop.

On September 16, there was another example, as SLV closed at $20.35, which was not far below the Starc+ band at $20.46. Over the following three days, SLV got as low as $20.06 before resuming its uptrend.

NEXT: Recent Examples in Apple and Netflix

|pagebreak|

chart
Click to Enlarge

At the April highs, there were no signs from the weekly chart using either indicator that a top was in place. The Bollinger bands were continuing to widen, but sometimes they will contract or narrow as a top is being formed. The Starc bands were warning for several weeks before the highs, as SLV closed just $0.25 below the weekly Starc+ band the week ending April 9.

The following week, SLV closed $0.40 above the Starc+ band, followed by $2.50 above the same band the next week. SLV traded $1.00 above the weekly Starc+ band as the SLV made its high at $48.35. The weekly doji formation was a good clue that time might be running out.

From personal experience, when a market has closed above the weekly Starc+ band and I don’t close out at least part of my position the following week, I have regretted it about 90% of the time.

chart
Click to Enlarge

I find that being able to use the same settings and interpretation for the Starc bands on any market and any time frame, from monthly to hourly, is a distinct plus. On the weekly chart of Apple Inc. (AAPL), there are two examples of what is often observed when prices reach the Starc+ band.

The week ending September 25, 2010 (point 1), AAPL closed at $292.32, just below the Starc+ band at $295.55. AAPL moved sideways for two bars, dropping as low as $275 before resuming its uptrend.

Just three weeks later, APPL closed at $314.74 (point 2), not far below the Starc+ band at $320.50. In a strong uptrend or downtrend, it is typical for prices to correct or move sideways for two to four bars after a Starc band is tested.

The daily chart of Netflix Inc. (NFLX) covers the volatile period from February to June 2011. In February, as the overall market was topping, NFLX closed above the daily Starc+ band (point 3), and the weekly Starc band at $245 was also exceeded.

Clearly, it was a high-risk time to buy, as NFLX dropped from a high of $247.55 to a low of $205.39 just six days later (point 4). NFLX moved sideways for two bars before resuming its downtrend. The March lows of $188.89 came fairly close to the weekly Starc- band at $182.55.

NFLX rallied impressively from the lows and quickly reached the Starc+ band (point 5) at $223.37 before closing the day lower. The 50% support held on the two-day pullback before NFLX again turned higher.

If the strength of NFLX caught your eye and you were looking to buy around $223, the close proximity to the Starc+ band suggested caution. Buying at the 38.2% support at $209.98 with a stop under $201.80 (61.8% support) would have worked out well, as the correction bottomed at $207.32. Less than three weeks later, NFLX was trading over $245.

Three other extremes have been highlighted, as NFLX closed above the Starc+ band on April 25 (point 6), and just two days later, it was back to the Starc- band, point 7. The last example came this week, as NFLX closed at $270.80, which was just below the Starc+ band at $273.44, before turning lower.

As you can likely tell from this article, the Starc bands are tools that I use on regular basis. For each of my positions, I monitor the daily Starc bands and write down the weekly Starc bands during my weekend analysis.

They also do a good job of keeping me from jumping in on either the long or shot side. If I get that uncontrollable urge to buy or sell, the closeness to a Starc band will often convince me to wait.

I use the Bollinger bands more sparingly, as I look at them when my volume analysis on a market suggests a major bottom or top is being formed.

For example, last week, my on-balance volume (OBV) analysis suggested that natural gas may be bottoming. The weekly Bollinger bands on the natural gas futures have now narrowed to their lowest level in two years, and a band width breakout will confirm a major low.

With any indicator or methodology that you decide to use in your own trading or investing, it is critical that you study it on your own before using it as a basis for your trading decisions. Only once you have become convinced of its validity will you have the confidence to make decisions when the time is right.

Tom Aspray, professional trader and analyst, serves as senior editor for MoneyShow.com. The views expressed here are his own. Readers can post questions or feedback in the comments area below or send to TomAspray@MoneyShow.com.

Related Articles on STRATEGIES