This week’s article is a little overview of the former article and expands on the necessity of investing consistently and not being afraid of volatility in the markets. This will be different because I will be using some technical indicators to show the power and the resiliency of the stock market. Now it should be mentioned that higher liquidity in our economy this particular year means that the “dips” have been bought with more ferocity, but I do believe that this is a recurring theme and will not stop anytime soon.
Technical Indicator Number One - Bollinger bands
Bollinger bands are created by taking the 20 day simple moving average and finding 2 standard deviations up and below this number. For example, let's assume that over the last 20 trading days, the simple average of the close of each of those days has been $120, with a standard deviation of $5. Our top bollinger band will be at $130, while the bottom will be located at $110, with the 20 SMA in the middle. If anyone has taken statistics or is familiar with it will know that anything between 2 standard deviations of the mean can be considered “statistically normal”. This means that if we price movies outside of this channel that we have created by using the standard deviations, we can consider this statistically abnormal. We saw a statistically abnormal occurrence happen most recently with the default of Chinese retail group, Evergrande this Monday.
We saw the S&P plunge through the lower band of the channel; creating a statistically abnormal event. If there is anything that we can learn by looking at this picture is that anytime the S&P has penetrated through the lower band, we can treat it as a buying opportunity. Every single time the S&P has approached or broken through the lower band the S&P has recovered within an incredibly short period of time.
It is evident that any statistically abnormal event to the downside this year has been a significant buying opportunity. Bollinger bands are incredibly useful tools for an investor or trader. This indicator can let investors know when a specific change in price movement is abnormal. This useful information can be used by anyone to help them make a decision on whether to pull the trigger. I think this tool can really benefit anybody. Obviously, timing the market is not the best strategy, but by knowing if you truly are getting a good discount relative to a short term basis, bollinger bands are an incredibly useful strategy.
Technical Indicator Number 2 - RSI
The second chart is the S&P’s Relative Strength Index or RSI. The 8 circles points correspond to the 8 points from above on the bollinger band chart. Using multiple indicators to make the best investment decision is key to any investment strategy. Combining the bollinger bands (which is a tool to tell if we are experiencing a statistically normal event or not) with the RSI which is a momentum indicator can tell us many important data points. Using these two tools in tandem can show that we are at an unusually low point in the lower band, so - we may have hit a bottom in terms of price. Additionally, the RSI is at a low level in momentum, and over the past year, RSI has always rebounded, meaning once we have hit this low in momentum, we usually get a bunch of positive momentum in the coming days. All of this combined with our overall macro outlook on the markets should allow us to make a decision. For example, we know there is a bunch of liquidity in the system and the dips have been bought every single time in the past year. We know we are a statistically unusual point in terms of our price range and we are the lows in momentum.
This combination of events should allow us to come to the conclusion that a strong rebound in momentum and price will push us back into our bollinger band range, and back above our RSI level of support at 37. In the last few days of the market we have seen exactly that. The S&P has quickly rebounded back within our bollinger bands and price and RSI have bounced.
What can we make of this?
I think in the future we can use this event and the events of the past year to help us determine when we want to step in and buy. I mean these graphs have just been absolutely spot on and perfect. There is nothing better than seeing this constant bounce for the same level every single time. It truly has been spectacular to watch. Finally, I urge whoever may be interested in the markets or maybe are worried when they see a large dip in the market, be confident that 9 times out of 10, you'll get a bounce. I hope that from the article you'll be able to recognize not only when the dip has occurred, but you will know when to step in on a trade.
"the time to buy is when there's blood in the streets."
- Graphics made by me with Yahoo Finance