In 2005, a flock of 1,500 sheep began jumping off a cliff for no real reason.
In the middle of a clear blue day, they just started jumping. All shepherds could do was watch.
And as insanely ridiculous as this sounds, some of us are those sheep.
Sadly, this very same thing happens each and every day among traders and investors.
We buy because everyone else does. We sell because everyone else does. But we never question what we’re really buying or selling, which can be quite costly.
Instead, we take the leap simply because everyone else is doing it. At the same time, it offers smart traders an opportunity with two extremes – overbought and oversold conditions.
And to be honest, spotting these isn’t difficult at all.
In fact, we can use the rubber band approach, otherwise known as mean reversion. Remember, if we pull a rubber band too far, it snaps back. The same thing happens with stocks at extremes.
While there are multiple ways to identify just how far the rubber band has been pulled with relative strength (RSI), MACD, money flow (MFI) and Williams’ %R (W%R), we can also look at Bollinger Bands and Keltner Channels.
When it comes to Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands. Bollinger Bands allow users to compare volatility and relative price levels over a period of time. They consist of three bands:
- A simple moving average (SMA) in the middle
- An upper band (SMA plus 2 standard deviations)
- A lower band (SMA minus 2 standard deviations)
Look at Micron Technology (MU) for example.
Notice what happens about 80% of the time when the upper or lower Band is touched or penetrated. It pivots and reverses.
We can also look at the Keltner Channel (KC).
Keltner Channels are volatility-based lines set above and below an exponential moving average (EMA). This indicator is similar to Bollinger Bands. Instead of using the standard deviation, though the KC use the Average True Range (ATR) – which looks at the degree of price volatility -- to set channel distance.
We can again look at MU and see that the stock also stays within the parameters of the Keltner Channel, just as it does with Bollinger Bands.
Again, though, just because the KC or BB highlights a potential opportunity, it is crucial that you always confirm with other indicators.