STOCKS GAP HIGHER AND TRY TO REGAIN 20-DAY AVERAGE -- S&P 500 HAS ALSO BOUNCED OFF LOWER BOLLINGER BAND -- THOSE BANDS SHOW STOCKS PULLING BACK FROM OVERBOUGHT TERRITORY BUT STILL IN UPTRENDS -- LOWER BB VOLATILITY IS ALSO SUPPORTIVE TO STOCK PRICES
STOCK INDEXES GAP HIGHER TODAY... After gapping lower yesterday, stocks are gapping higher today. The daily bars in Chart 1 show the S&P 500 also trying to regain its 20-day moving average (green line) that was violated yesterday. If this morning's gap to the upside holds through the rest of the day, that would leave a small "island reversal" behind which would be a positive sign. [An upside island reversal takes place when a downside gap is followed shortly by an upside gap; and usually signals a short-term bottom (see red circle)]. In addition, the S&P 500 remains well above its 50-day average (blue line) and trendline support along its July/September highs. Since I mentioned the 20-day average yesterday, I'm going to spend today discussing a technical indicator that is based on that 20-day average. That indicator has a lot of other useful information as well. I'm referring to Bollinger Bands.
SPX BOUNCES OFF LOWER BOLLINGER BAND...The lower box inChart 2 shows the same chart of the S&P 500 with daily Bollinger Bands overlaid on the price bars. It shows the SPX bouncing off the lower band yesterday and trying to regain its 20-day average today. Daily Bollinger Bands (named after John Bollinger) show two outer bands surrounding a 20-day moving average which is the dotted middle line. Those outer bands are plotted two standard deviations above and below the 20-day average. And they often provide short-term support and resistance levels. In other words, prices often pull back from the upper band; and bounce off the lower band. As they appear to have done yesterday. That's an encouraging sign. But there's more to those three lines.
BOLLINGER %B... The green line in the upper box in Chart 2 plots the Bollinger %B indicator. That indicator provides a way to study the relationship between the three lines in an oscillator format which helps define potential overbought and oversold levels. In the upper box, the same three lines are shown. The flat middle line represents the 20-day moving average. The Bollinger %B indicator shows how far prices have moved above and below that middle line. And it can be used to spot overbought and oversold areas. The upper red line shows that a reading of 1.0 often represents an overbought market. While drops near -.40 represent oversold levels.
OVERBOUGHT AND OVERSOLD READINGS... The last two times the Bollinger %B indicator pulled back from overbought territory was during July and September which led to stock pullbacks. The last two oversold readings took place at the early August and October bottoms. The trigger for those pullbacks was the drop below the flat 20-day average. Which brings us to this week's market action. The indicator dipped slightly below its 20-day line yesterday which would normally be a caution signal. But it's trying to regain its 20-day line today. In other words, a close back above the 20-day line would be a positive sign for the SPX. Even if it doesn't, the proximity to the lower band suggests that any downside risk from here could be relatively limited. But there's more.
BOLLINGER BAND WIDTH MEASURES VOLATILITY...The third way to use Bollinger Bands is with Bollinger Band Width. That indicator measures the width between the two outer bands. That's the green line in Chart 3 overlaid on daily price bars for the S&P 500. The indicator is based on the idea that the outer bands expand or contract depending on market volatility. A rising green line suggests that volatility is rising which usually leads to lower prices. A lower line is more supportive to rising prices.
Chart 3 overlays the Bollinger Band Width indicator (green line) on daily price bars for the S&P 500 over the last two years. The red arrows show previous instances of a spike in the green line which led to stock selloffs. Two big ones took place near the start of 2018 and again near its end. The green line peaked at the end of last year which marked a major upturn in stock prices. Smaller upturns in the green line took place this year during May and August as stock prices pulled back. A more modest upturn during September led to a modest pullback in stocks. The green downtrend line, however, shows that the Bollinger Band Width line has been declining since mid-August which reflects declining market volatility. And there's no sign yet of that changing.
VOLATILITY REMAINS LOW... The Bollinger Band Width indicator is near its lowest level of the year. That could suggest that stocks are somewhat overbought. For a serious downside correction to occur, however, the green line would have to start rising. So far, there's no sign of that happening. Which suggests that stocks don't appear to be in imminent danger of a serious selloff.
LONGER-RANGE BANDS... Bollinger Bands can also be applied to weekly and monthly charts for longer-range analysis. In both cases, 20 periods are used as the middle moving average line (20 weeks or 20 months) Those longer range versions also show the stock market somewhat stretched to the upside; but with uptrends still solidly in place.
