Choppy markets can be intimidating. The constant zigzagging can put some people off.
Yet if you’re avoiding this kind of action, you’re probably leaving plenty of profits on the table.
Commodities are a good example of this. People sometimes put commodities in the “too hard” basket because the swings can be difficult to trade.
You only need to see the chart of the Invesco DB Agriculture Fund (DBA) to understand what I mean. This ETF holds a broad range of commodities like sugar, cocoa, coffee, corn, meats, wheat, and cotton.
DBA bounces around all over the place. (Even so, these moves can be quite mild compared to some of the massive breakouts and collapses in individual commodities, which is why DBA is a popular way to trade this sector.)
So today, I want to show a technical tool that can help you navigate (and profit) from these kinds of situations…
It’s something that should help with the choppiness we’re seeing now all across equity markets…
Spotting Potential Reversals
On the chart below, we’ve included Bollinger Bands (the upper blue lines). This is a great tool to help determine when a stock is overbought or oversold.
Invesco DB Agriculture Fund (DBA)
Source: e-Signal
The upper and lower bands show the typical price movement a stock can expect. Statistically speaking, 95% of the price action will appear between these two lines.
The bands tend to stretch wider during periods of higher volatility. And they come closer together when the price isn’t seeing much movement.
The middle orange line is the 20-day moving average (MA). It helps determine the overall trend (and any countertrends).
So Bollinger Bands can help gauge volatility. Yet they are also useful for finding potential changes in direction. And that’s what I want to focus on today…
When the stock movements stretch near either of the blue lines, prices will likely reverse the other way. That fits right into our mean reversion strategy.
Remember, when stocks stretch too far in one direction, they tend to “snap back” like a rubber band. And we can profit by anticipating those moves.
Take another look at the chart:
Invesco DB Agriculture Fund (DBA)
Source: e-Signal
Look at the rallies that began at “1” through to “6”…
Yet DBA sometimes tracked along the lower blue line for an extended period before reversing higher. So if we had just bought DBA when it first traded at the lower Bollinger Band (lower blue line), we would likely have lost money in any potential trade.
That’s where the Relative Strength Index (RSI) can help time potential reversals more precisely…
DBA’s troughs and reversals from “1” through “6” coincided with the RSI forming a ‘V’ (black arrows) and rallying from near oversold territory (lower gray dashed line at the 30% level).
You can see the opposite effect from “A” to “E” where DBA tracked along the upper blue line for extended periods before reversing lower. If we shorted DBA when it first traded at the upper blue line, we likely would have lost money in any potential trade.
However, by combining the Bollinger Bands and the RSI, we greatly increase our chances of success.
And even if you don’t want to trade DBA, you can use these indicators with your own trading…
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Extra Confirmation
Bollinger Bands help identify when a stock is on the edge of its trading range and could be vulnerable to a reversal.
Yet we need another signal to help with timing our trade. That’s why you can reference the RSI to identify an imminent change in direction. By combining Bollinger Bands and the RSI, you’ll greatly improve your chance of success.
So, for example, say the RSI forms a ‘V’ and bounces from oversold territory. You’d look for the stock to rally off the lower blue Bollinger line as extra confirmation.
The opposite also applies…
If the RSI makes an inverse ‘V’ (or diverging pattern) from overbought territory, you’d look for a down move with the stock reversing lower from the upper blue Bollinger line.
Remember, though, that we don’t necessarily need a change in the overall broader trend.
Instead, we’re looking for when a stock has overshot in either direction. That can help us profit from a short-term move when it snaps back the other way.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict