Chapter 17: Bollinger Bands and Indicators

reason to do so; e.g., indicators from other categories are not available (substitutions allowed, but at a price).

Volume and sentiment indicators fit particularly well into a diversification strategy to avoid the multicollinearity trap. Why? Because they introduce new, independent variables that are probably not already considered in the analysis and are therefore unlikely to be collinear with other elements of the analysis. Momentum and trend indicators, being directly derived from price, are already duplicating some of the data the eye gleans from the charts and are therefore less useful than volume or sentiment indicators.

Another very dangerous indicator trap is sycophantism. Dictionary.com defines sycophant as "A servile self-seeker who attempts to win favor by flattering influential people."1 The last thing you want is indicators that behave like sycophants, flattering you by confirming your opinion, telling you what you already know, or worse, what you wish to hear. The time that this trap most often bites is when the user looks through a number of indicators until one is found that confirms the analysis. Desperate for a reason to make a trade, confirmatory evidence is eagerly sought after-never a good idea to start with-and the sycophant trap strikes. To avoid the sycophant trap, choose your approach or tools before the trade and then stick with them. Other indicators appropriate to the situation can be consulted, but avoid hunting expeditions for confirmatory evidence.

It is very important that you choose your indicators and do whatever testing you are going to do before you start looking for trades. Having selected the analytical tools, create a template(s) to use for your analysis. Figure 17.7 is a good example of a basic template. The top clip is a log-scaled candlestick chart with Bollinger Bands and a 50-day average. Log scaling makes percentage changes comparable anywhere on the chart, candlesticks highlight the important relationship of the open to the close, Bollinger Bands provide a relative definition of high and low, and the 50-day average gives a sense of trend. Overlaid in the same clip but plotted with a separate scale is relative strength-the ratio of the stock to the S&P 500, which gives a feel for how the stock is doing in relation to the market. In the chart clip directly below the price clip is 21-day Accumulation Distribution plotted as an oscillator; this is our indicator for confirming price action. Finally, in the

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Figure 17.7 Analytical Template I, CVS, 150 days. Use tags setup regularly. Adding the relative strength to the market really helps.

bottom clip, volume is plotted as a function of its 50-day average, which is useful for clarifying price patterns.

Another example of a useful template starts with a log-scaled candlestick chart and then plots Accumulation Distribution as a line in the same clip as price, but on its own scale (Figure 17.8). Then moving average convergence/divergence (MACD) is plotted in a separate clip. A clip with normalized volume completes this stack.

Having built a template(s) that suits your analytical approach, now review your stocks looking for setups. Then make your decisions without introducing extraneous, untested factors. Failure to follow these guidelines, or another rigorous methodology, can lead you along the path to destruction via emotions. Pick your indicators and create your analysis templates before you trade!

A related matter to the idea of picking indicators, building templates, and sticking with them is that your indicator choices must derive from first principles; i.e., you must know why they work2 and what test results you are expecting before you

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Figure 17.8 Analytical Template II, AT&T, 150 days. A stronger focus on volume indicators in the setup really helps pick the low here.

test and choose. Using indicators not grounded firmly in practical considerations and not fully understood will result in insufficient confidence to execute the system when the times get rough, or, for that matter, when the times get too good! It is at the extremes that our emotions impact our actions to the greatest degree. Unless you have the highest level of confidence in your approach, youll find it impossible to stick to it when the emotional climate becomes volatile.

All the tools and techniques presented in this book arise from first principles. That is, they are firmly footed in the underlying reality of the marketplace and their motive forces are well understood. An example of developing a technique from first principles starts with the idea that volume precedes price. One could build an indicator based on that idea by comparing volume with its 50-day average during a period in which price was building a base, theorizing that there ought to be a coincident bias to firming prices and firming volume before the base is completed and the breakout occurs. Having laid out the theoretical grounds, formulate the indicator and test it to see whether you are correct.