Bollinger bands

Momentum Trading Strategy

by

Momentum Trading Strategy

Akshit GUPTA

This article written by Akshit GUPTA (ESSEC Business School, Master in Management, 2019-2022) explains the momentum trading strategy.

Introduction

The momentum trading strategy is a strategy where a trader buys a security when its market price starts to rise and then sells it when its price seems to have reached a top. Similarly, a trader sells (or short sells) a security when its market price starts to fall and then buys it back when its price seems to have reached a bottom. In other words, if we observe a positive price change or return today, we are long tomorrow, and if we observe a negative price change or return today, we are short tomorrow.

This trading strategy is based on the direction of the price trend (up or down) in the market and its relative strength. The rationale behind the momentum trading strategy is that, for an upward trend, if there is enough buying force behind the rise in the price of an asset, it will keep on rising until a strong selling pressure is seen in the market to reverse the trend. Similarly, for a downward trend, if there is enough selling force behind the fall in the price of an asset, it will keep on falling until a strong buying pressure is seen in the market to reverse the trend.

Momentum trading is a trading strategy with a short-term horizon where traders try to capture and profit from the price trend. The period for implementing a momentum strategy can range from a trend forming within a day or over several days. Momentum traders try to identify the strength of an ongoing trend in a particular direction and take a position. The strength can measured by different technical indicators discussed below. Once the strength of the trend begins to fall, the trader exits the position at a profit.

Momentum traders are least concerned about the fundamentals of the company for which the stock is to be traded. They rather use various technical indicators to understand the trend in the stock price, especially its strength.

Implementation

Figure 1 below illustrates the implementation of the momentum trading strategy for Apple stock over the period from April 1, 2020 to March 31, 2021.

Figure 1. Implementation of the momentum trading strategy for Apple stock.
Implementation of the momentum trading strategy for Apple stock
Source: computation by the author (data source: Yahoo Finance).

In Figure 1, an upward trend can be seen forming in the period from November 22, 2020 to November 25, 2020 in the price of Apple stock. The trader following a momentum strategy will go long on the Apple stock till the momentum is in the upward direction. The right time to exit the long position is around December 2, 2020. By following this trend, the trader can capture a price movement of around $10 which is approximately 8%-9%, by going long on the Apple stock.

Momentum trading indicators

Momentum trading indicators help the trader to look for the formation of a trend and the signal of an entry/exit point, and also indicate the strength of that signal. We present below some of the most common indicators used to assess the strength of the trend: relative strength index (RSI), moving-average convergence-divergence (MACD) and Bollinger bands.

Relative Strength Index (RSI)

The RSI indicator is a technical indicator and is plotted on a chart which ranges from 0 to 100. It helps a trader in knowing the relative strength of a trend formation. The indicator is an oscillator which provides overbought or oversold signals based on the positioning of the line in the chart. During the uptrend, if the line crosses the 70 mark, an overbought signal is considered for the given security. Symmetrically, during a downtrend, if the line crosses the 30 mark, an oversold signal is considered. Momentum traders generally take a position in between in the indicator instead of waiting for a price reversal when the line crosses the given thresholds. For example, a trader can use the halfway mark of 50 to get an idea about the formation of a trend. If the RSI line crosses the 50 mark and is moving in an upward direction, it can show the high strength of the upward forming trend and the trader can take a long position in the respective stock.

Figure 2. Relative Strength Index of Apple stock.
Relative Strength Index of Apple stock
Source: computation by the author (data source: Yahoo Finance).

Moving-average convergence-divergence (MACD)

The moving-average convergence-divergence (MACD) is a technical indicator based on the moving averages of prices over a period of time. The indicator helps in understanding the direction and strength of a trend. It also helps in understanding the rate at which the change in trend is happening.

The indicator is shown by two lines namely, the MACD line and the signal line. The MACD line is the difference between two exponential moving-averages, a long-term moving-average like a 26-day moving average and a short-term moving-average like the 12-day moving average. The signal line is made up of the 9-day exponential moving-average of the MACD itself and is placed on the same graph. A bar graphs plotted on the zero-line (X axis) showing the difference by which the MACD line is below/above the signal line. Generally, the indicator is used to understand the degree of the bullish or bearish sentiments in the market. If the MACD line crosses the signal line from below the zero-level moving upwards, it indicates a bullish trend. In such a scenario, a trader practicing momentum strategy would take a long position in the market seeing the trend.

Figure 3. Moving-average convergence-divergence of Apple stock.
MACD of Apple stock
Source: computation by the author (data source: Yahoo Finance).

Bollinger bands

The Bollinger bands is a very popular technical indicator that represents the volatility in the prices of a financial asset. The indicator consist of three lines, namely, a simple moving-average (SMA), and an upper band and a lower band. The simple moving average is usually computed over a rolling period of 20 trading day (about a calendar month for the equity market). The upper and lower bands are usually set by default to two standard deviations away from the simple moving average.

The width between the upper and lower Bollinger bands provides a range for price changes in the market (an indicator of volatility). The bands help to identify the overbought or oversold situations in the market for an asset. They can be used by a trader to identify possible entry or exit prices to implement the momentum trading strategy.

Figure 4 represents the Bollinger bands for Apple stocks. The price of the Apple stock is touching the lower band on November 2, 2020 and reverting just after that. This can be a signal for the momentum trader showing a trend reversal and the trader can take a long position in this stock till the price touches the 20-day SMA line which happens around November 5, 2020, thereby capturing a price movement of $8 approximately.

Figure 4. Bollinger bands of Apple stock.
Bollinger bands of Apple stock
Source: computation by the author (data source: Yahoo Finance).

Market conditions

Market liquidity and market volatility play a major role in the implementation of a momentum strategy.

A liquid market is generally preferred by traders in order to quickly enter and exit the market.

Stock price volatility is a major factor affecting a momentum trader’s decision to enter/exit a trade. A highly volatile stock can provide a good opportunity for a trader to earn high profits using this strategy as the asset prices can change dramatically in a short period of time. But a high stock volatility can also lead to huge losses if the prices move in an unfavorable direction.

The figure below represents the historical daily volatility (standard deviation of returns over rolling 10-day periods) of Apple stock over the period from April 1, 2020 to March 31, 2021.

Figure 5. Volatility of Apple stock.
Volatility of Apple stock
Source: computation by the author (data source: Yahoo Finance).

You can download below the Excel file for the computation of the different momentum trading indicators mentioned above.

Download the Excel file to compute the momentum trading indicators

Risks associated with momentum trading

Although momentum trading is a commonly used strategy, the risks associated with it are quite high. The trader using this strategy should be careful about:

  • Entering the position too early
  • Exiting the position too late
  • Relying on rumors and fake news
  • Missing the indication of a reversal in the direction of the trend
  • Not applying a strict stop loss rule

Link with market efficiency

Market efficiency refers to the degree to which all the relevant information about an asset is incorporated in the market prices of that asset. Fama (1970) distinguished three forms of market efficiency: weak, semi-strong, and strong according to the set of information considered (market data, public information, and private information).

In the weak form of the market efficiency hypothesis, the current market price of an asset incorporates all the historical market data (past transaction prices and volumes). The current market price of the asset is then the best predictor of its future price.

In a market efficient in the weak sense, the autocorrelation of asset price changes or returns is close to zero.

A positive autocorrelation coefficient would imply that after a price increase, we should likely observe another price increase, and symmetrically, after a price decrease, we should likely observe another price decrease, leading in both cases to price trends.

The implementation of a momentum strategy assumes that the autocorrelation of price changes is positive, which contradicts the efficient market hypothesis.

In a market which is efficient in the weak sense (implying an autocorrelation close to zero), momentum trading strategies should not exhibit extra profit as traders are not be able to beat the market on the long run.

Related posts

   ▶ Jayati WALIA Bollinger bands

   ▶ Jayati WALIA Moving averages

   ▶ Akshit GUPTA Growth investment strategy

Useful resources

Academic research

Fama E.F. (1970) Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance 25(2): 383-417.

Fama E.F. (1991) Efficient Capital Markets II: A Review of Theory and Empirical Work, The Journal of Finance 46(5): 1575-1617.

Business analysis

Fidelity Learning center: Momentum trading strategy

About the author

Article written in May 2022 by Akshit GUPTA (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

Bollinger Bands

by

Bollinger Bands

Jayati WALIA

In this article, Jayati WALIA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents the popular Bollinger bands used in technical analysis.

This post is organized as follows: we introduce the concept of Bollinger bands and provide an illustration with Apple stock prices. We delve into the interpretation of Bollinger bands as port and resistance price levels used to define buy and sell trading signals. We then present the techniques to compute the Bollinger bands and finally discuss their limitations.

Introduction

In the 1980s, John Bollinger, a long-time market technical analyst, developed a technical analysis tool for trading in securities. At that time, it was presumed that volatility was a static quantity, a property of a security, and if it changed at all, it would happen in a long-term period. After some experimentation, Bollinger figured that volatility was indeed a very dynamic quantity and a moving average computed on a time period (typically 20 days) with bands drawn above and below at intervals could be determined by a multiple of standard deviation.

Unlike a percentage calculation from a simple moving average, Bollinger bands simply add and subtract a standard deviation (or a multiple of the standard deviation, usually two). The tool thus represents the volatility in the prices of the security which is measured by the standard deviation of the prices of the security. The bands are used to understand the overbought or oversold levels for a security and to follow the price trends. The indicator/tool comprises of three main bands, an upper band, a lower band, and a middle band.

The middle band is a simple moving average (SMA), which is usually computed over a rolling period of 20 trading days (about a calendar month). The upper and the lower bands are positioned two standard deviations away from the SMA. The change in the distance of the upper and lower bands from the SMA determine the price strength (which is the strength of price trend of stock relative to overall market trend) and the lower and the upper levels for the stock prices. Bollinger bands can be applied to all financial securities traded in the market including equities, forex, commodities, futures, etc. They are used in multiple time frames (daily, weekly and monthly) and can be even applied to very short-term periods such as hours.

Figure 1 represents the evolution of the price of Apple stocks with the Bollinger bands for the period January 2020 – September 2021.

Figure 1. Bollinger bands on Apple stock.
Bollinger bands Apple stock
Source: computation by the author (data source: Bloomberg).

Figure 2 illustrates for the price of Apple stocks the link between the Bollinger bands and volatility measured by the standard deviation of prices. The lower the volatility, the narrower the bands.

Figure 2. Bollinger’s bands and volatility
Bollinger bands and volatility Apple stock
Source: computation by the author (data source: Bloomberg).

How to interpret Bollinger bands

Traders use the Bollinger bands to determine the strength of the price trend of a stock. The upper and lower bands measure the degree of volatility in prices over time. The width between the bands widens as the volatility in the stock prices increases and indicates a strong trend in the price movement. Conversely, the width between the bands narrows as the volatility decreases, indicating that the price of the security is range-bound. When this width is extremely narrow and contracting, it indicates that there can be a potential breakout in the price movement soon and is referred to as “Bollinger squeeze”. If the price crosses the upper band, it may indicate that the movement will be in an uptrend, and If the price crosses the lower band, it may indicate that the movement will be in a downtrend.

If the price hits the upper band, it indicates an overbought level in the security, and when the price hits the lower band, it indicates an oversold level. When the price crosses the upper band, traders consider it to a positive signal to buy the stock as the price trend is in an upward direction and shows great strength. Similarly, when the price crosses the lower band, traders consider it to a positive signal to sell the stock as the price trend is in a downward direction and shows great strength.

In other words, Bollinger bands act as dynamic resistance and support levels for the price of the security. Thus, once prices touch either of the upper or lower band levels, they tend to return back to the middle of the band. This phenomenon is referred to as the “Bollinger bounce” and many traders rely extensively on this strategy when the market is ranging and there is no clear trend that they can identify.

Calculation

The three bands of the Bollinger bands are calculated using the following formula:

Middle Band

The middle band is the simple moving average (SMA) over a 20-day rolling period. To calculate the SMA, we compute the average of the closing prices of the stock over the past 20 days.

SMA 20 days

To compute the upper and lower bands, we need first to compute the standard deviation of prices.

img_std_dev_bollinger_bands

Upper band

The upper band is calculated by adding the SMA and the standard deviation times two:

Bollinger upper band

Lower band

The lower band is calculated by subtracting the standard deviation times two from the SMA:

Bollinger lower band

Limitations of Bollinger bands

Bollinger bands are considered to be lagging indicators since they represent the simple moving average which is based on the historical stock prices. This means that the indicator is not very useful in predicting the future price patterns as the indicator signals a price trend when it has already started to happen.

To benefit from the Bollinger bands, traders often combine this indicator with other technical tools like the Relative Strength Index (RSI), Stochastic indicators and Moving Averages Convergence-Divergence (MACD).

Related Posts

   ▶ Jayati WALIA Trend Analysis and Trading Signals

   ▶ Jayati WALIA Moving averages

   ▶ Jayati WALIA Standard deviation

Useful resources

Bollinger bands

Fidelity: Technical Indicators: Bollinger Bands

About the author

The article was written in November 2021 by Jayati WALIA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Trend Analysis and Trading Signals

by

Trend Analysis and Trading Signals

Jayati WALIA

In this article, Jayati WALIA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents an overview of trend analysis and trading signals in stock price movements.

This post is organized as follows: we introduce the concept of trends used in technical analysis and its link with support and resistance price levels used to define buy and sell trading signals. Then, we present the different types of trends and discuss the time frame for their analysis. Trends based on straight lines, moving averages and the Fibonacci method are presented in detail with examples using Moderna, Intel, Adobe and Apple stock prices.

Introduction

Trend Analysis is one of the most important areas of technical analysis and is key to determining the overall direction of movement of any financial security. The analysis of trends in asset prices is used to find support and resistance price levels and in fine generate buy and sell trading signals when these support and resistance price levels are broken.

Support and resistance

The support and resistance are specific points on the price chart of any security which can be used to identify trade entry and exit points. The support refers to the price level at which price generally bounces upwards and buying trend is strongest. Likewise, the resistance price is a price level at which selling power is strongest and the price of the security struggles to break above the resistance. The support and resistance levels can act as potential entry and exit points for any trade since it is at these levels that the price can either “break-out” of the current trend or continue moving in the same direction. The support and resistance can be determined by using prices or Japanese candlesticks.

Ways to define trends

The two main ways to define trends in financial markets are straight lines and moving averages. Straight lines simply give static support and resistance levels that do not change over time. Moving averages give dynamic support and resistance levels that are continuously adjusted over time. Another popular method to define trends is the Fibonacci method.

Trends based on straight lines

Overview

Trend lines are indicators to identify the trends in the price chart of a security within a time frame (say one week or one month). Trend analysis using trend lines takes specific price levels or zones that correspond to support and resistance. An uptrend is based on the principle of higher highs and higher lows; similarly, a downtrend is based of lower highs and lower lows.

These price levels are the major zones where the market seems to respond by making a strong advance or decline. If the stock prices are in an uptrend, it shows an increasing demand for the stock and if the stock prices are in downtrend, it shows an increasing supply for the stock.

Trend lines can be built by connecting two or more prices (peaks or troughs) in either direction of a stock price movement on a time frame determined by the trader (1 hour, 1 day, 1 week, etc.) over a period (3 months, 6 months, 12 months, etc.). For a trend line to be valid, a minimum of two highs or lows should be used. The more times price movement touches a trend line, the more accurate is the trend indicated by the line.

Different types of trends using straight lines

The use of market trends in technical analysis in financial markets is based on the concept that past movements in the prices of the stock provides an overview of the future movement. Note that such an approach is in contradiction with the Market Efficiency Hypothesis (EMH) developed by Fama (1970), which states that the best prediction of the price of tomorrow is the price of today (past prices being useless).

The prices of any financial asset in the market follows three major trends: up, down and sideways trends.

Up trend

When the stock prices follow an uptrend, it means the prices are reaching higher highs and higher lows on a pre-determined time frame (decided by the trader). The higher high of a stock price is the highest it reaches in each time frame and the lower lows is the lowest it reaches in that time frame. The constant rise and fall in the stock prices show that the market sentiments are bullish about the stock and the trader tries to buy the stock when it is at its lowest in the uptrend.

The following figure shows an upward channel trend in Moderna stock prices using Japanese
candlesticks. As observed in the graph, both the upper and lower trend lines connect minimum two peaks and troughs respectively. As the price crosses the upper trend line (resistance level), it enters an uptrend (or a bullish trend) indicating a buy signal.

Figure 1. Uptrend in Moderna stock.

Uptrend in Moderna stock

Source: computation by the author (data source: Bloomberg).

Down trend

A downtrend comprises of lower highs and lower lows in the prices of the stock. The stock prices follow a downward sloping trend, which shows a bearish sentiment in the stock. The traders resist to enter in a long position when the stock prices are in down trend.

The following figure shows Intel stock prices in a downtrend (or bearish trend) represented by upper and lower straight trends lines. When the price crosses the lower trend line (support level), it will enter into a downtrend indicating a sell signal.

Figure 2. Downtrend in Intel stock.

Downtrend in Intel stock

Source: computation by the author (data source: Bloomberg).

Sideways trend

In such a trend, the stock prices move in a sideways direction and the highs and lows of the stock price are constant for a period of time. Such price movements make it difficult for the trader to predict the future price movements of the stock. The trader trading in this stock tries to anticipate potential breakouts above the resistance level or below the support level. He or she enters in a long position when the price of the stock breaks the upper resistance level. Also, he or she can benefit from the sideways movement by entering in a long position when the stock prices retrace from the support level, to enjoy the stream of profits till the price reaches the resistance level.

Figure 3. Sideways trend in Adobe stock.

Sideways trend in Adobe stock

Source: computation by the author (data source: Bloomberg).

Trends based on moving averages

Overview

A moving average is an indicator to interpret the current trend of a stock price. A moving average basically shows the price fluctuations in a stock as a single curve and is calculated using previous price, hence it is a lagging indicator.

To measure the direction and strength of a trend, moving averages strategy involves price averaging to establish a baseline. For instance, if price moves above the average, the indicated trend is bullish and if it moves below the average, the trend is bearish. Moving averages are also used in development of other indicators such as Bollinger’s bands and Moving Average Convergence Divergence (also known as MACD).

The moving average indicator can be of many types, but the simple moving average (SMA) and exponential-weighted moving average (EWMA) are most commonly used. An n-period SMA can be calculated simple by taking the sum of the closing prices of a stock for the past ‘n’ time-periods divided by ‘n’.

Crossovers of moving averages is a common strategy used by traders wherein two or more moving averages can help determine a more long-term trend. Basically, if a short-term MA crosses above a long-term MA, the crossover indicates a downtrend and vice-versa indicates an uptrend. Traders can utilize it establish their position in the stock.

Example: Apple stock

Consider below the APPLE stock price chart using Japanese candlesticks. The lines in blue and yellow indicate 20-day (or 20-period) SMA and 50-day SMA respectively. We can observe that while the 2 lines are indicative of the movement of stock price fluctuations, the 20-day SMA is closer to the actual price movement and responds more quickly to price change.

We can also observe a crossover in the moving averages wherein the 20-day MA is crossing below the 50-day MA indicating a down trend in price movement.

Figure 4. Moving averages on Apple stock.

Moving averages in Apple stock

Source: computation by the author (data source: Bloomberg).

Fibonacci Levels

Fibonacci levels are a commonly used trading indicator in technical analysis that provides support and resistance levels for price trends. These levels can be used to determine more accurate entry and exit points by measuring or predicting the retracements before the continuation of a trend.

Fibonacci retracement levels are counted on numbers of the Fibonacci sequence (0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55 and so on). Each number (say 13) amounts to approximately 61.8% of the following number (13/21=0.618), 38.2% of the number after (13/34=0.382), and 23.6% of the number after (13/55=0.236).

Fibonacci analysis can be applied when there is an evident trend in prices. Whenever a security moves either upwards or downwards sharply, it tends to retrace back a little before its next move. For example, consider a stock that moved from $50 to $70, it is likely to retrace back to, say, $60 before moving to $90. Fibonacci levels can be used to identify these retracement levels and provide opportunities for the traders to enter new positions in the trend direction.

Example: Moderna stock

Consider below the Moderna stock price chart using Japanese candlesticks. We can see an evident uptrend (indicated by the straight trendlines in blue). The Fibonacci retracement levels have been plotted and we can notice that the ‘61.8% Fibonacci level’ intersects the rising trend line. Thus, it can serve as a potential support level. Further, it can also be observed that the price bounces from the 61.8% level before rising up again and it would have been a good entry point for a trader to take up a long position in the stock.

Figure 5. Fibonacci levels on Moderna stock.

Fibonacci levels in Moderna stock

Source: computation by the author (data source: Bloomberg).

Time frame

Trends also can vary among different time frames. For example, an overall uptrend on the weekly time frame can include a downtrend on the daily time frame, while the hourly is going up. Multiple time frame analysis can thus help traders understand the bigger picture. Some trends are seasonal while others are part of bigger cycles.

The trend analysis can be done on different time horizons (including short term, intermediate term, and long term) to identify the price trends for different trading styles.

Related posts on the SimTrade blog

   ▶ Jayati WALIA Bollinger Bands

   ▶ Jayati WALIA Moving averages

   ▶ Akshit GUPTA Momentum Trading Strategy

Useful resources

Academic articles

Fama E.F. (1970) Efficient Capital Markets: A Review of Theory and Empirical Work, The Journal of Finance 25(2): 383-417.

About the author

The article was written in November 2021 by Jayati WALIA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).