Hi Gush,
Here's a "real-life" example of contracted BBs, and how I analyze them.
I came across the chart of ISLE late Friday night.
Message 20848295
I noticed that the BBs had gotten very contracted, and appeared to reverse on Friday, forming a bullish candle that day off support from the 40 sma (roughly equivalent in this case to the 40 ema). I posted that here, along with another similar chart (GRA):
139.142.147.218
Notice that the last time the BBs were contracted, the stock exploded off support (the rising 40 sma). And notice the reversal candle that formed last Thursday right on support from the rising 40 sma (this coincides with a rising trendline):
stockcharts.com[w,a]daclyyay[dc][pd20,2!b40][vc60][iLyb20,2.0]&pref=G
This happened in September, and very dramatically in early November, as you can see.
So, I figured it was highly likely that ISLE would rally up from that support level. The extreme oversold technicals and strong buy signals corroborated that interpretation. So did the candlesticks, which were quite bullish.
ISLE did indeed rally, and moved up to the upper rail as I anticipated over the past several sessions. But now it has been turned away from that rail (which tends to represent resistance). So now what?
Well, the BBs are more contracted than ever, so this must be resolved soon. This can happen by the stock pushing strongly against either rail. But since the stock is in an uptrend, the likelihood is that this will be resolved by the stock rallying sharply against the upper rail, rather than failing here and pushing open the bottom rail.
It doesn't HAVE to do this... the situation can also be resolved by the stock bouncing from one rail to the other, widening the BBs more gradually rather than explosively. This is possible, because the slope of the BBs is not sharply upwards, but rather just gently upsloping now. The 20 sma (which is the middle of the BBs), is in fact exactly horizontal.
Generally, when the 20 sma is upsloping, the stock has a bias to trade in the upper half of the BBs, and when the 20 sma is downsloping, the stock trades more in the bottom channel. The middle of the channel (the 20 sma) represents a potential reversal point, because it is relative support or resistance. Sometimes a stock will bounce back and forth from the middle of the BBs to one rail and back in a quite periodic and orderly fashion.
So with ISLE, because the technical picture is strong, and because the stock is in an uptrend, I think the upper rail of the BBs will soon get pushed open. Today's candle suggests a short term move back towards the middle of the BBs, but if that happens, that will only increase the likelihood of a powerful move up, because that will make the BBs even more contracted.
Right now, the BB width is 1.92. It has only been that contracted 3 other times in the last 6 months. On each of these occasions, the contraction was resolved with a powerful push up against the upper BB rail as the stock rallied sharply:
stockcharts.com[w,a]daclyyay[dc][pd20,2!b40][vc60][iLyb20,2.0]&pref=G
So, my prediction that ISLE will resolve the current BB contraction in the same way is consistent with the previous history of this stock and its personality, and also has support from the technical indicators and moving average and trendline support levels.
By the way, I am neither long nor short this stock, but I may take a long position soon. I would have went long on Friday or Monday, but I have too many positions as it is, and not enough time to adequately follow them and manage them.
An interesting option strategy known as a straddle could be used in this kind of situation: buy both calls and puts, both at the money (possibly, in a ratio of 2 calls for every put, or maybe 3:1). Then, if I am wrong, and the stock falls apart and pushes open the bottom rail, it will probably be obvious rather quickly. Then the long positions can be closed for a loss, and the profitable short positions held and just allowed to run. This is a relatively low risk options play, based on the premise that the stock cannot go sideways with highly contracted BBs forever----it has got to make some kind of move one way or another, very likely sooner rather than later.
Notice I said "relatively" low risk.... it is not always low risk, it depends on the stock and its particular chart/technical situation, and the pricing of the options. It also depends upon the expiration of the options you choose.... you must pick an expiration that allows sufficient time for the stock to move, before the time value of the options starts to decrease exponentially. Generally, that means the expiration month should be at least 3 months away, preferably closer to 6 months. A straddle will be profitable if the stock moves sharply, and relatively soon; it doesn't matter which way the move is, up or down. If the BBs have gotten gradually contracted, or if they have been contracted for a prolonged period of time, then the volatilities have probably decreased also, and that means the prices of the options contracts will very likely be cheap, since they depend upon recent volatility.
Hope this helps,
Terry |
