If you pull a rubber band too far, what happens?
It snaps back, right?
The same thing happens with stocks when they become too overbought or oversold. And if we can position ourselves for the exact moment the “snap back” happens, we make money.
And it’s actually quite easy to spot with three key technical indicators:
Bollinger Bands (2,20)
Named after John Bollinger, the Bands are typically placed two standard deviations above and below a moving average. For example, a trader may choose to use an intermediate-term moving average of 20 with two standard deviations above and below that average.
The idea behind such bands is simple.
When a stock – or index – touches or penetrates the lower band, the situation can be considered oversold. When a stock touches or penetrates the upper band, it can be considered overbought.
Relative Strength (RSI)
We can use RSI to confirm other indicators above. When RSI moves to or above the 80-line, we have an overbought condition. When RSI moves to or below the 20-line, we have an oversold condition. It confirmed what Williams was telling us.
Williams % Range (W%R)
When Williams moves to or above its -80, it’s an indication the asset is oversold. When it moves to or above the -20-line, it’s overbought.
For the pivot strategy to work, each of these indicators must now agree with the others.
Agreement among the three indicators is essential to pinpointing potential reversal.
And it doesn’t just work with stocks, it also works with indexes.
Let’s use the Russell 2000 Small Cap Index (RUT) as our example.
Let’s start with the Bollinger Bands (2,20) on the Russell 2000.
Notice what happens up to 80% of the time on the Russell 2000 when the upper Band is touched or penetrated. The RUT begins to pivot lower. Using the Bands, we can tell a RUT move is greatly overdone in overbought or oversold territory.
However, we never want to rely on just one indicator. So, we can add relative strength (RSI).
Notice what happens as the RUT hits or penetrates its upper Band, as RSI pushes to or above its 70-line. We can tell with up to 80% accuracy a pivot is likely to happen. Or, look at what happens at the lower Band with RSI at or below the 30-line.
We can also add in Williams’ %R (W%R). Look at what happens when W%R pushes to or above its 20-line, as the RUT peaks the upper Band, and as RSI peaks at 70. Or look at what happens when W%R is at or below 80 with RUT at its lower Band with RSI at 30.
We see a pivot begin to take shape.
It’s just something to keep in mind if you’re looking to trade volatility in the new year.