Greetings, fellow Pro-fundity team members.

In this lesson we will continue our study of technical analysis, adding “Bollinger Bands” to our tool box. This is a variation of the envelope channel we discussed in lesson 9. Additionally, we will look at fundamental analysis with a first look at stock quality (value), or what makes a stock “good.” Thirdly, we will look at specific price charts and messages that help, and finally, review pick performance over the past two weeks.

Bollinger Bands

1. In lesson 8, the last session on exits, we discussed variation as we introduced the Average True Range (ATR) to help set stops. A stop is to be far enough away from the price action to prevent “noise” from kicking us out, yet close enough to minimize the loss when a true assignable (not random) price drop occurs. The ATR is a simple measure of price volatility (or, how much is “noise”) to help us set stops. It would be well to review lesson 8 with this study. Now, in the parlance of statistics, a measure of variation called “standard deviation” provides a more powerful indicator. It is not so simple and for that reason less well known in the investing sandbox. However, John Bollinger, introduced his bands using this measure in a very helpful way. Let’s first look at this “standard deviation.”

2. The “Normal” is the most popular distribution in statistics. It fits many real-life situations very well and has neat math properties that let us make strong statements about data from samples. A graph of the normal distribution is shown in Fig. 1. This is the familiar bell-curve with equal sides around a zero center. Now, notice the vertical line through the circle at the point of inflection, where the curve changes direction. The distance from the center to this line is defined as “one standard deviation” and given the name “sigma (s).” Sigma (s) is one standard deviation wide in any normal distribution. In Fig. 1, notice how almost the entire normal curve fits between –3s and +3s.
   
   
   Fig. 1 Normal Distribution with Standard Deviation (sigma)

3. Next, the math properties mentioned can be seen in the following figure. It is helpful to consider how the normal curve is generated in nature. In a room of 100 avid investors the heights of the group will fit a normal distribution. There will be an average height (the center of the curve) with about equal numbers above and below this center. Now, within two and three sigma limits, the percentages shown let us make strong predictions. It is this principle used with Bollinger Bands.
   
   
   Fig. 2 Percentages within 2 & 3 sigma.

4. You may ask, how can that be? Wherever normal distributions occur, the principle is true. But, true to what degree? It is true to the degree that a distribution is truly normal. There lies the rub, true normal distributions occur only with very large sample sizes. As well, they are true so far as the data that makes up the population is random by nature. So we have limitations. In the market we have seen the data (price patterns) are made up of both random and assignable observations. With that background, let’s look at the marvelous work offered by John Bollinger with his bands.

5. First, review the pattern of a trading envelope as shown in Fig. 3. This envelope channel has its upper band some value above a moving average of the price, with the lower band below by the same amount with the vertical width of the envelope a constant. The moving average is normally not shown, but provides the center of the envelope. The width of the envelope can be selected according to the price volatility, where the upper band signifies an overbought condition (get ready to sell) and the lower band the oversold case (get ready to buy). The envelope becomes support on the bottom and resistance on the top.
   
   
   Fig. 3 Trading Envelope on FLWS.

6. The problem with this approach lies in the envelope, where we can adjust the width to fit a particular price pattern. For example, if I leave the envelope where it is on FLWS and bring up another ticker, SOHU, the bands are violated as shown below. SOHU is a more volatile issue, thus the width for FLWS is not good for SOHU. I can modify the width to conform to the new price pattern, vary the channel width with each ticker, but that is troublesome. There should be a better way.
   
   
   Fig. 4 The Same Envelope on SOHU.

7. After extensive study John Bollinger introduced the Bollinger Bands in 1982 where the trading bands measure the volatility of the price pattern. He calculates the “standard deviation” of price data, fixing the new trading bands some multiple of the standard deviation above and below a moving average. This represents the same technique used with the trading envelope, however the width or distance between upper and lower band depends on the volatility (or variation) of the price pattern. The default values used in these bands include a 20-day sample for both a simple moving average and the standard deviation, with the width of the channel being 2-standard deviations above and below the moving average. From Fig. 2 above, ±2-standard deviations would include about 95% of all data in the population, however with such a small sample size (relatively, being about one month of data) the bandwidth contains 88 to 89% of the data points. That means only about 10% of all price points will fall outside the bands. Look at figures 3 & 4 redrawn below with Bollinger bands.
   
   
   Fig. 5 FLWS with Bollinger Bands.
   
   
   Fig. 6 SOHU with Bollinger Bands.

8. Bollinger bands are drawn in and around the price structure on the chart. They provide relative definitions of high and low; prices near the upper band are high, prices near the lower band are low. To satisfy the market adage “Buy low, sell high,” Bollinger Bands help identify where “High” and “Low” are on a price chart. Now, the first important value of this approach is that it works on any price pattern with any level of variation. Additionally, price pattern proximity to the bands will teach us many valuable lessons about future price direction. We will consider how Bollinger Bands can improve our trades with the “double-bottom (W)” and “double-top (M)” patterns in the next lesson.

9. Most charting programs have Bollinger Bands as an option. Our default program, TC2000/TCNet, places BB’s on an existing price pattern in the simple manner shown below.
   
   
   
   
   Fig. 7 TC2000/TCNet chart setup for Bollinger Bands.

10. The first figure shows the edit screen for an existing price chart with options to add. The second figure shows how Bollinger Bands’s are added. The default values chosen show a sample size of 20 bars (suggesting how it might be used on weekly or monthly charts) and 2 standard deviations band width (the 20 designates 2 Standard Deviations).

    Fundamentals

11. Before we plug “value” into our discussion, lets consider a few basics that apply to all markets in all time frames. Variation is a constant in both the stock market and in the world of business. When investor Bernard Baruch was asked what the stock market would do in the future he replied, “It will fluctuate.” The same is true in business, as well as in the general economy. The truly great businesses, those that have been around for generations, have used variation as opportunities to widen their lead over competitors. How is this possible? Long-term success hinges on the ability to adapt to changing conditions. This ability to adapt, to ride out ugly downturns, results in better competitive positions in business and greater success in the market.

12. Jack Welch, CEO of General Electric, suggested that great companies take advantage of periods of fluctuation and uncertainty. “The time to put the pedal to the metal is when everyone else is hunkering down. That’s your chance to widen the gap.” His comment applies equally well to investing. Warren Buffett’s counsel on how to invest successfully, “Be fearful when others are greedy. Be greedy when others are fearful.” A rather thoughtful insight into how great minds work. This environment of variation takes on heavy meaning and importance to us in our investing/trading efforts. Whether we are classic long-term buy & hold investors, e.g. Buffett, or day-traders flitting in and out of positions with seconds as critical time elements, we live with variation, with fluctuations over which we have no control! But like Jack Welch, it is how we react, how we adapt to this variation that spells the difference between success and failure.

13. Stock value plays a critical role. The size of this role depends on our investing time frame. A day-trader cares little about what is behind the company brand name, while a long-term B&H investors depends entirely upon that. Those of us in the middle, swing-traders to moderately longer term investors, can benefit by understanding the concept of value and what it means to the price of a stock stock-price changes. This segment is our first foray into the fundamentals of companies behind the price charts.

14. First point: Value is not stock price, stock price is not a measure of company value. The continual fluctuations of stock prices capture our attention in the news, but it is the actual business operations that determine company value. That means market averages are irrelevant to the long-term investor. Since the market first allowed traders to trade, the one single most important factor in price appreciation over the long term has been company earnings. The strongest correlation favoring price has been earnings. Fundamental analysis attempts to forecast the future value of a stock by analyzing current and historical company strength. Analysts try to determine if the stock price is over- or under-valued and what that means to its future. There are hundreds of factors that play into this determination, trying to put a reasonable price on the value of a stock. Remember, price is not value, although fundamentalists attempt to equate the two, or to find the “right” price for the value. In this study, a company value that appears undervalued (price less than the perceived value) is thought to be a good buy. The reason for this is the “Market” should eventually move price and value together, the premise of the “efficient market.”

15. That said, our position is not that fundamental analysis is better than technical analysis, or vice versa, rather there is much to learn from both camps. Therefore, as we continue our study of TA tools and techniques, we will also consider important fundamentals so that at the end of the day (end of this course and beyond), we can make credible choices about our own trading system. That trading system will be our own, one we have confidence in, one we are able to execute with discipline, and one we can keep learning with. This is not a forum for directive guidance. Rather, one where we can try different methods, different systems, techniques, tricks and tips, rising with an old friend we can take to the bank! That is our objective.

16. Earnings: Company earnings are profits after taxes and expenses. It is a company’s earnings, more than anything else, that create value. These earnings are reported as earnings per share, EPS. This measure puts all companies on a level playing field, dividing quarterly earnings across all shareholders. A company’s EPS can be a powerful measure to help forecast the future of a stock’s price. EPS is probably the most widely used fundamental ratio. The growth of this ratio is also important to company value.

17. The P/E ratio is another useful measure of whether a stock is fairly priced. If a company stock is trading at $60 per share and its EPS is $6 per share, it has a multiple, or P/E of 10. This means that investors might expect a 10% return on their investment;
    $6 / $60 = 1/10 = 1 / (PE) = 0.10 = 10%

    If it is earning $3 per share, it has a multiple of 20 (20 times $3 equals $60). In this case, an investor might receive a 5% return (if conditions remain the same going forward);

    $3/$60 = 1/20 = 1/(PE) = 0.05 = 5%

18. It seems a stock with a lower P/E ratio would be the higher value. However, that is not always the case. Certain industries have different P/E’s. Banks have low P/E’s – say, in the 5 to 12 range. High tech companies have higher P/E’s – say around 15 to 30. The real value or use of the P/E ratio is in comparing companies within the same industry. As far as valuing a company with earnings, it is future earnings that will pay us, not a historical record. That means we need to pay as much attention to estimates of future earnings as to those current. Studies prove that the percentage gain in earnings has a greater impact on a stock’s price than its conventional EPS or P/E ratios. It is an easy matter to find the EPS and P/E ratio for any stock you consider. The ticker symbol on each price chart with our weekly picks is a link to company fundamentals. Look at each ticker posted this week and find these two fundamental ratios, EPS and P/E. Then compare companies in similar sectors to see if one seems to have better fundamentals.

19. We’ve spoken of the need to find a trading system that becomes your own, rather than a cut-n-paste duplicate of what works for someone else. Sure, we can buy trading systems offered in bulk on the net and in the media. However, we’ll most often find that the results differ from what we expected or what was offered. There is an old market adage, “Teach a dozen investors a trading system, and when you come back a year later, you’ll find a dozen systems.” To be successful, we must learn to think for ourselves. We must fashion a system that not only works, but can be executed. No system – however profitable, will work if we are unable to follow it.

20. Independence and independent thinking are the keys. It is comfortable to go with the crowd and do as others are doing – or as they tell you to do. Yet this road is fraught with peril. Consider Robert Frost’s “The Road Not Taken.”
    Two roads diverged in a yellow wood,
    And sorry I could not travel both
    And be one traveler, long I stood
    And looked down one as far as I could
    To where it bent in the undergrowth.

    Then took the other, as just as fair,
    And having perhaps the better claim,
    Because it was grassy and wanted wear;
    Though as for that the passing there
    Had worn them really about the same.

    And both that morning equally lay
    In leaves not step had trodden back.
    Oh, I kept the first for another day!
    Yet knowing how way leads onto way,
    I doubted if I should ever come back.

    I shall be telling this with a sigh
    Somewhere ages and ages hence:
    Two roads diverged in a wood, and I –
    I took the one less traveled by,
    And that has made all the difference.

21. Our path, created, maintained, and traveled by ourself, will be that path less traveled, for it will be ours and ours alone; no one else will be able to follow it, just as we will be unable to follow anyone else’s path successfully. We do not share their vision, their sensitivities, or their cares, and they do not share ours. In investing, there is no holy grail other than the one we fashion for ourselves.

22. Enjoy!
    Be Diligent
    Take Action!

    

    
    
    
    
    

    
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