Math isn't everyone's favorite subject, but it can be the key to your next triple-digit profit.
But fortunately, great technicians like John Bollinger have put the power of math at our fingertips. They've done all the hard work of making it easy for us to find stocks that have been stretched, beaten down, or hugely inflated, and are ready to snap back the other way.
And that's why today, I'm showing you three ways you can put these folks to work for you to score your next massive winner.
The only math you'll have to do is figuring out how much cash you've made.
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Using Statistics to Score Your Next Big Profits
Stocks and stock volatility tend to return to the mean or average. This is called "reversion to the mean," or "mean reversion." Think of it like a stretched rubber band. Stretch it, release it, and it "reverts" to average tension.
Last week, we talked about how momentum slows as a stock on the run is ready to go the other way... and return to its average. Stochastics, another mathematical formula, calculates this for us.
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This week, I want to show you how Bollinger Bands can be used to predict when a "stretched" stock is ready to return to normal.
Invented by John Bollinger, Bollinger Bands use statistics to determine the probability of a snap back. By applying "standard deviation" to a 21-day moving average, this indicator determines how much a stock's price has been stretched. Typically, Bollinger Bands use two standard deviations to plot upper and lower bands, as shown on the chart of the SPYs below:
As you can see, the shaded area contains most of the price action - 95% of it, to be precise.
When a stock touches or crosses the outer limits of the band, it tends to snap back the other way. This makes sense when you consider that the stock will only be outside of the bands 5% of the time.
The SPY chart shows a number of signals that correctly called a nice directional trade. It also shows a few false signals or consecutive touches before actually snapping back. For this reason, it's important to confirm Bollinger Bands with other indicators like MACD, RSI, stochastics, support/resistance, trend lines, and volume. John Bollinger himself suggests the use of confirming indicators.
The Quiet Before the Profit Storm
Stocks ready for a breakout often act like storms. Things get quiet right before the action. Bollinger Bands also reveal when a stock has gotten quiet and poised for a breakout. Called "The Squeeze", this is revealed when the bands get closer together than normal. In early October, Bollinger Bands revealed a "squeeze" that was followed by an 11% correction in the market.
Stocks in a squeeze are great candidates for a straddle. When you see a squeeze, consider placing an at-the-money (ATM) straddle using 60-90 day options.
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To help narrow it down for you, here are my top 10 S&P 500 stocks poised for a breakout. They're dynamite straddle candidates:
Playing Directional Breakouts
Stocks that are making the biggest moves and offering the best profits are also revealed by Bollinger Bands. When a stock makes a strong move outside of the bands, they tend to keep on moving. Check out the strong moves identified on Phillips 66 (NYSE: PSX) below:
On three occasions, Phillips 66 broke outside of the band and kept on going, stretching the "rubber band" to its limits.
It's important to confirm a strong breach of the bands by using other technical indicators as mentioned above. My favorite is above-average volume coupled with trend lines and/or support/resistance.
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Here are my top 10 bullish Bollinger Band breakouts in the S&P 500:
As you can see, Bollinger Bands are very versatile - an excellent complement to your technical analysis arsenal - leading you to the biggest profits.
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About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.