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The Rubber Band Effect: Part 1

May 18, 2015

What happens when you pull a rubber band too far, too tight?

It snaps back, right?

Well, the same thing happens to stocks, especially those driven by extreme fear and greed.  Which means just about every stock you can think of.

The beauty of trading the rubber band effect is just how easy they are to spot, exploit and profit from over and over again.

You can literally retire rich by trading the opportunity.

One way is to look for an elevated put to call ratio.

Another way is to look for parabolic moves in either direction.  Or simply watch your favorite stock – driven by fear and greed – move.

We can begin our search by looking for over-extensions to the upper or lower Bollinger Band.  These bands let us know how far we can pull the rubber band.

Take a look at what happens here with Bed Bath & Beyond (BBBY), for example.

About 80% of the time when the upper or lower red Band is touched or penetrated, we see a bounce… The rubber band was pulled too tight.

But just what is a Bollinger Band.

With Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands.

They allow us to compare volatility and relative price levels over a period of time, consisting 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).

However, the Bollinger Bands are just a single indicator. We can’t just rely on a single indicator and move forward with great confidence in a bounce.

We need confirmation.

And one of the best ways to confirm potential rebound off a Band is by using Williams % Range (W%R) – the ultimate momentum indicator that signals oversold and overbought conditions. W%R shows an overbought condition with a range of zero to 20. Oversold conditions are measured with a range of 80 to 100.

Now look at the same chart above but with Williams now used.

When Williams gets too oversold at -100, as the stock nears the lower Bollinger Band, the stock bounces. When Williams gets too overbought at zero, as the stock challenges the upper Bollinger Band, again we see a bounce.

Does this work 100% of the time? Absolutely not…

But it comes close.

Having the ability to screen for such moves on a daily basis – as we do – get us one step closer to retirement dreams.


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