The coolest thing about the stock market is the great diversity of ideas on the best way to make money. Every investor has their favorite tactic and method to extract profits from changing prices. The interesting thing is that every method works but only some of the time.
The above means to be successful for the long run; you need to have an arsenal of styles and tactics to apply as the market’s volatility changes.
Most importantly, understanding the two primary market philosophies is the first step in developing your investing plan.
There are many different styles of trading. However, all the techniques boil down to two primary methods of approaching the market. I am not talking about fundamental analysis or technical analysis here. I am going far deeper than analysis techniques.
These two primary styles are based on your philosophical viewpoint of the stock market and often life in general.
The two major trading methods are quantitative and discretionary.
Discretionary traders use intuition honed from years of watching price charts, level two screens, and the time & sales tape. The successful discretionary traders can identify subtle repeating patterns within the price to exploit.
There are traders who still use, sometimes very successfully, discretionary methods.
Due to a huge uptick in computer-driven high-frequency trading, the discretionary approach is becoming much harder to do successfully. Make no mistake about it, discretionary trading can still be used successfully, it’s just much more difficult today.
The reason for this is the old reliable price patterns are often thrown out of whack due to the extreme short term volume from high-frequency trading tactics.
The next primary trading method is known as quantitative. Quantitative trading relies on statistics, math and data to make buy and sell decisions. High-frequency trading is quantitative in nature. However, the variables that are used to make decisions are often proprietary to the particular firm.
Quantitative traders use computer programs to analysis price movements to locate anomalies to exploit. It is by far the most popular and successful active trading method today. The majority of today’s hedge funds, institutions, and large traders use quantitative methods to make decisions.
It is often mean reverting rather than trend following.
Mean reverting means that the trader waits for the price to pull back to the mean, or average price, and then expects the price to bounce back in the direction of the dominant trend.
Multiple academic studies have shown that stock prices are mean reverting on a short term basis with a long-term upward drift. This is the basic philosophy of mean reverting.
Trend following is just like the name suggests; it attempts to follow the trend. Trend followers buy stocks as they break out of trading ranges, make new highs or when price demonstrates upward momentum.
They sell stocks when price breaks down out of trading ranges, make new lows, and when price experiences downward momentum.
While trend following is much less popular than it has been in the past, it remains a very fruitful and popular trading method at times.
However, as you can see from the above chart, buying new highs isn’t always the smart thing.
The typical breakout trading strategies utilized by most all short-term traders is a form of trend following. In fact, the largest hedge funds in the world are trend following funds.
Technical quantitative trading also attempts to determine if the price is overextended in one direction or the other, so traders can “fade” the move by going in the opposite direction.
What Does This All Mean?
The majority of regular traders do not have the math skills, data sets, and programming knowledge to implement correctly many quantitative trading strategies.
Therefore, the default method for most active traders is discretionary trading via technical analysis. As was stated earlier, this tactic works when correctly implemented but the current market environment is making it much more difficult.
So, what is a regular trader to do?
The solution is a combination of discretionary trading with a quantitative bent. I know this may sound even more complicated, but there is a very easy solution.
There is a technical indicator that allows traders to visualize the quantitative while allowing for discretionary decision making. Rather than using statistics and programs to determine reversion to the mean or that price is overextended in one direction or the other; this tool enables these factors to be clearly seen on a price chart.
The best part is that this technical tool is built into most every trading platform and charting software. It is found for free on sites like stockcharts.com, and there is a tremendous amount of tutorial on this tool all over the internet.
In case you haven’t guessed it, I am referencing Bollinger Bands.
Bollinger Bands allow you to combine the benefits of both discretionary and quantitative trading into a unified whole. While they are not as accurate as real quantitative trading, and not as flexible as pure discretionary trading, Bollinger Bands provide the critical aspects of each in a simple to use format.
Let’s take a closer look:
Bollinger Bands are my favorite technical indicators. Over my investing career, I have found Bollinger Bands to be the perfect tool to quantify visually price moves. The best part is the fact that Bollinger Bands are extraordinarily simple to benefit from and very efficient for profiting from price changes
Bollinger Bands are moving averages that wrap around price bars on a stock chart. You are most likely familiar with moving averages. A moving average is a mean or average price of a series of prices. It is posted on the chart as a line with 20 period, 50 period, and 200 period being the most commonly used. The period can be anything from seconds up to months depending on the time frame that you are trading.
Bollinger Bands are made up of three moving averages. The middle band is the standard moving average, and the other two are set several deviations above and below the central simple moving average.
The bands get their name from their popularizer John Bollinger. He is credited with developing a statistically based standard for the price bands, building trading concepts around them, and popularizing their use.
Standard Bollinger Bands consist of a 20 period Moving Average, an upper band two deviations above the MA, and a lower band two deviations below the MA.
How To Use Bollinger Bands
The purpose of Bollinger Bands is to determine visually if the price is high or low on a relative basis.
This means high or low as price relates to the average, which is the middle line or 20 period MA on the stock graph.
The further away the upper band moves from the center, the more likely price is to revert to the middle or mean.
If the price bar pushes or breaks through the upper or lower band, traders will place a trade in the opposite direction with the anticipation that price will soon revert to the mean ( the middle line),
It is important to keep in mind that this doesn’t always work as expected. Price can travel along the upper or lower band for a long time prior to reverting to back to the average.
Therefore, this shouldn’t be used in and of itself as a buy or sell signal but rather as a confirmation tool for other indicators. For example, the price bar pierces the top line, but your other indicator does not confirm the bullish strength— this is a sell trigger. If the indicator does confirm and you are already in the trade, this is a sign to stay in the trade. The opposite is also true at the lower band.
It’s important to remember that the bands are better used as a technical analysis of stocks divergence confirmation indicator rather than a standalone trading tool.