December 4, 2009, Newsletter Issue #134: What are Investing Volatility Bands?

Tip of the Week

Volatility bands are used to identify stocks that are prone to enter a period of unusual strength or weakness. These bands are based on a short-term moving average and the stock´s own intra-day highs and lows to create upper and lower bands that move with the price action of the stock. As a stock´s intraday swings increase, the bands respond by flaring apart. If the stock has enough momentum, it can break outside these bands, a move we refer to as going "out of bands." We consider a high-probability long trade one in which the stock breaks above its upper band amid a pessimistic sentiment backdrop. Conversely, stocks with high levels of optimism that are breaking below their lower band would be considered potential short trades or put buying opportunities. There are two primary patterns associated with the volatility band strategy. The first is the "out-of-bands run," in which the stock breaks outside its bands and begins a rapid move to either the upside or the downside. The second pattern that we key on is the "break, consolidate, and pop" - the stock breaks outside its band, but rather than make an immediate move, it goes through a period of consolidation sideways before popping. As stated above, volatility bands are used to set up the trades. Once a stock breaks above or below bands, it triggers an alert to a possible trade. Since the width of the bands depends on the recent price action of the stock, the methodology will automatically tailor itself to every stock it is applied to. Volatility Bands vs. Bollinger Bands: One issue that frequently comes up concerns the difference between volatility bands and Bollinger bands. Bollinger bands are based on the standard deviation of closing prices over a set period of time, while the volatility bands calculation focuses on the daily range rather than just the closing price. A comparison of Bollinger versus volatility bands shows that Bollinger bands flare out more since they are designed to contain most of the price data. In contrast, the ability of a stock to trend outside its volatility bands is one of the keys to its strength. Many times, both sets of bands are close together and quick pops tend to break outside both bands at the same time. It is where the short powerful trends occur that volatility bands can have the advantage. The ability for a stock to "trend" outside these bands is what we generally look for. Volatility Bands vs. Regression Channels: Another question that often arises is how volatility bands differ from regression channels. The biggest difference is that regression channels are hand-drawn on a chart, while volatility bands are a mathematical calculation that the computer applies. Because volatility bands are always moving with the stock, they quickly adjust to price movements. Both methodologies have their advantages but will trigger different trades at different times.

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