The equity markets have drifted higher on weak volume since I last blogged two weeks ago. Today the Dow Industrials inched up 13 points to close at 17,647.15 while the S&P 500 Index ticked up .07%. The Nasdaq Composite slipped .37%. Small-cap stocks were hit harder, with the Russell 200 Index falling .82%. There are also concerns about Japan sinking into a recession.
Cold weather gripping much of the nation sent UNG, the natural gas ETF, up 5.40% on light volume. GDXJ, the junior gold miners ETF, gained 4.36% on heavy volume. SRTY, the leveraged short Russell 2000 Index EF, rose 2.40%. Please click on the symbols for details.
The Bollinger Bands are tightening on the VIX, the CBOE Options Volatility Index. This can lead to a “Squeeze,” the term John Bollinger coined for when the Bollinger Bands narrow and the Bollinger BandWidth decreases. Bollinger BandWidth is an indicator derived from the Bollinger Bands. StockCharts.com provides an excellent explanation of what Bollinger Bandwidth is and how it’s interpreted:
“BandWidth measures the percentage difference between the upper band and the lower band. BandWidth decreases as Bollinger Bands narrow and increases as Bollinger Bands widen. Because Bollinger Bands are based on the standard deviation, falling BandWidth reflects decreasing volatility and rising BandWidth reflects increasing volatility.”
Bandwidth is simply the difference between the value of the upper Band and the lower Band, divided by the value of the middle Band. When the BandWidth is narrow, volatility tends to be low and the range of an ETF is also narrow. Since one of the best ways to capture a gain is to buy or short when it breaks out of a narrow range, scanning for a narrow BandWidth can be an excellent method for finding ETF’s that are getting ready to break out.
But how narrow is narrow? Put another way, can “narrow” be quantified? The short is answer is Yes…and No. What’s narrow to one ETF may be wide to another. I find the most effective method is to look at a six month chart of an ETF with the Bollinger Bandwidth charted and look for periods of time where the Bands have narrowed. The Squeeze occurs when volatility is very low. The chart below shows the Bollinger Bands squeezing together on the VIX:
Below the VIX surrounded by its Bollinger Bands is the SPY and below that, the Bollinger BandWidth. The red line is measuring the degree of Squeeze. When the Bandwidth falls below .30, the Bands are squeezed together. Today’s closing Bandwidth was .3732, the tightest it’s been since in over six weeks. When the BandWidth falls below .30 there tends to be a sharp move shortly thereafter in the VIX and the stock market as volatility expands, i.e., reverts to its mean.
Last year, VIX Bandwidth started rising on December 2 and the SPY dropped 2.2% before bottoming. Not a huge decline but in May of this year when the Bandwidth narrowed to .1581 (May 15) and then expanded, the SPY never fell at all – on May 15 it closed at 187.40 and moved steadily higher until the end of July. In mid-September the BandWidth dropped to .1716 (September 11) and a few days later the S&P began what developed into a 7.7% pullback. So just because the BandWidth is narrowing and then expanding doesn’t necessarily mean the market will fall. All it means is that volatility is likely to pick up and the market will begin moving out of its range. Which direction that will be is up to you to determine.