2 Great Bollinger Band Trading Strategies

I recently updated Incredible Charts’ Bollinger Bands page to highlight two great trading strategies:

First, if you are not familiar with Bollinger Bands here is a quick summary of basic Bollinger Band trading signals.

Bollinger Band Squeezes

The traditional way of trading the Bollinger Band squeeze is on breakout above (or below) the bands after a squeeze. Now Microsoft had been trending upward since 2012 and another advance was likely. It is important to guard against fake signals in the opposite direction, like the one highlighted in mid-September 2016.

Microsoft Bollinger Band Squeeze with Twiggs Money Flow

  • Green arrow = Long entry
  • Red arrow = Exit
  • The red candle on Friday, September 9th closed below the lower band after a narrow Bollinger squeeze, signaling a downward break, before a large engulfing candle on Monday warned of reversal to an up-trend. The primary trend would alert traders to treat shorter-term bear signals with caution but it is also advisable to use Twiggs Money Flow to confirm buying or selling pressure. Here 21-day Twiggs Money Flow is oscillating above zero, indicating buying pressure despite the downward breakout. So the trade would be ignored.
  • Subsequent rising troughs on Twiggs Money Flow would give me sufficient confidence to enter the trade [green arrow] before the next breakout, with a stop below the recent low at $56. More cautious traders would wait for breakout above the upper Bollinger Band but this often gives a wider risk margin because the stop should still be set below $56. The subsequent pull-back to test support in November 2016 underlines the need not to set stops at the breakout level.
  • Exit [red arrow] on bearish divergence on Twiggs Money Flow, when the second dip crosses below zero, or if price closes below the lower Bollinger Band.

Bollinger Band Trends

The second strategy is a trend-following strategy I picked up from Nick Radge’s book Unholy Grails, where he uses 100-day Bollinger Bands to capture trend momentum. The rules are simple:

  • Enter when price closes above the upper Bollinger Band
  • Exit when price closes below the lower Bollinger Band

Nick proposes setting the upper band at 3 standard deviations and the lower band at 1 standard deviation but I am wary of this (too much like curve-fitting) and would stick to bands at 2 standard deviations.

Here I have plotted Microsoft with 100-day Bollinger Bands at 2 standard deviations and 13-week Twiggs Money Flow to highlight long-term buying and selling pressure.

Microsoft Bollinger Band Trends

For a detailed discussion of trading signals for this chart, go to Bollinger Band Trends.

Concentrated Portfolios: Do they enhance performance?

I mentioned last week that concentrated portfolios tend to outperform widely diversified portfolios in the long-term. This 2013 article from Money Management offers support:

Fund managers who invest in concentrated portfolios are able to outperform those who invest in diversified portfolios by 400 basis points, according to research coming out of the United Kingdom.

Investment skills consultancy firm Inalytics examined nearly 600 equity portfolios in its database and found that portfolios with the lowest quartile of holdings performed over 400 basis points better than the highest quartile of holdings.

Inalytics chief executive Rick Di Mascio said there were a number of explanations for the research findings including manager skill set, survival bias and greater attention being given to smaller equity sets.

“One possible rationale is that only the most skilful managers are given the punchier portfolios to run. A good analogy is that only the very best racing drivers get to drive Formula 1 cars.”

“Another explanation is that the database may be biased towards successful managers who were given the opportunity and ‘survived’. Once again there is a parallel with the Formula 1 drivers, but at least in the case of fund managers it isn’t dangerous,” Di Mascio said.

“Third, from a behavioural finance perspective, the literature suggests that the lower the number of holdings in the portfolio, the more attention each one receives.”

“Whatever the explanation, the data is clear — the more concentrated the portfolio, the more likely the performance is going to be good,” he says.

Our own research with momentum portfolios overwhelmingly indicates that greater concentration leads to improved performance. But this is no free lunch. With increased performance comes increased volatility. Which is why you need a long investment horizon when investing in concentrated portfolios.

Eliminating emotional bias

Selling pressure from the September quarter-end is now abating. Although we may see further tests of support, this is likely to be followed by a surge in buying from long-term investors. At which point you can congratulate yourself for sticking to your position and not succumbing to temptation to cut losses and run.

The daily media cycle fuels indecision. There are always interests best served by opposing views of the market. Those not in the market would love to see it fall. And those in the market, or who derive an income from market activity, want it to rise. Most will seize on any evidence that supports their view and promote it for all they are worth. Any attempt at objectivity is lost. Treat with suspicion any source that does not present both sides of an argument before delivering a conclusion.

We try to counter any inherent bias using two measures. The first is to employ a disparate set of macroeconomic and volatility filters to identify elevated market risk. Using set rules enforces discipline and reduces emotional bias. But that on its own is insufficient. The second step is to continually examine evidence that conflicts with your conclusion in order to assess whether your model of the economy warrants revision.

Our market indicators continue to indicate low risk, despite the current correction, and we maintain our bullish view on stocks.

A tough time in the market

This has been a tough few weeks for investors and may continue for several more. My advice, however, is: Don’t change your strategy. If your plan was to stay in the market and ride out secondary movements, stick to your plan. Investors are notorious for selling at the wrong time and buying at the wrong time.

Weak economic data out of Europe is likely to hold back the market until the reporting cycle, that started with positive earnings surprises from Costco and Alcoa this week, is well under way. None of our macroeconomic and volatility filters indicate market stress and we believe the best strategy is to maintain existing exposure to equities.

Liquefied Natural Gas [LNG]

LNG had a less than auspicious introduction to the ASX 200, with a sharp sell-off in the last few weeks. There are signs that buyers are returning to the stock, with a strong blue candle on Friday when most other stocks were falling. We recommend that investors continue to hold the stock, at least for the next few weeks.

S&P 500 VIX

Market turbulence

The quarter-end sell off may depress stock prices for a few more weeks, but it is important to stay in the market if you are investing with a long time horizon. Inexperienced investors tend to sell at the wrong time and buy at the wrong time — buy high and sell low — whereas more experienced hands will treat secondary weakness as a buying opportunity.

To err is human

From Miles Udland at Business Insider:

[James O’Shaughnessy of O’Shaughnessy Asset Management] relays one anecdote from an employee who recently joined his firm….

O’Shaughnessy: “Fidelity had done a study as to which accounts had done the best at Fidelity….They were the accounts [of] people who forgot they had an account at Fidelity.”

There are numerous studies that explain why this happens. And they almost always come down to the fact that our minds work against us. Due to our behavioural biases, we often find ourselves buying high and selling low.

I have always called this “the Siemens effect” from an example I came across, in a completely different field, about 30 years ago. German electronics giant Siemens built a telecommunications exchange in a sealed container, with no human access and all maintenance conducted from an outside control panel. The exchange experienced only a small fraction of the equipment failures experienced in a normal telecommunications exchange, leading to the conclusion that human intervention by maintenance staff caused most of the faults.

Likewise in investment, if you build the equivalent of a sealed system. Where there is no direct human intervention, you are likely to experience better performance than if there is constant tinkering to “improve” the system.

The caveat is, during an electrical storm it may be advisable to shut down the telecommunications exchange from the control panel. Likewise, with stocks, when macroeconomic and volatility filters warn of elevated risk, the system should move to cash — or assets, like government bonds, with low or negative correlation to stocks.

When to sell and when to buy?

Investors are faced with the same emotional tug-of-war at every correction: Do I sell and abandon my positions or do I sit tight and ride out the storm? Here are a couple of useful perspectives:

What is your investment time frame?

Do you plan to invest for the long-term (5 to 10 years) or is your investment horizon a matter of months or weeks? If your investment horizon is long-term, you are investing for the primary trend. Your intention is unlikely to be to time secondary market movements.

Is timing secondary corrections profitable?

Our research shows that the average re-entry point, after brokerage and slippage is higher than the exit point and erodes performance.

Has the earning capacity of stocks you hold been affected by the correction?

A correction is a wave of negative sentiment, normally caused by an external shock — like the prospect of higher interest rates, oil prices, some new conflict or a threat to international trade. Where the market decides that earnings are unaffected and there is no permanent loss of value, it tends to recover fairly quickly. If, however, the market decides that there is a long-lasting effect on earnings then stocks are likely to be re-rated — resulting in a long-lasting drop in value. The probability of the former is far higher than the latter: the ratio of primary to secondary adjustments is low.

When is the best time to hold Momentum stocks?

We have not done a wide-ranging study of this, but the best two months performance for our ASX200 Prime Momentum strategy in the last two years were July 2013 (11.00%) and February 2014 (9.04%) — both in the middle of corrections.

ASX 200 Corrections

Attempt to time the correction and you may miss the best-performing months.

Diversification – the only ‘free lunch’ in investing

Diversification is often referred to as “the only free lunch in investing” because it affords investors the opportunity to reduce investment risk without reducing returns. Most investments involve a trade-off between risk and return, with higher returns requiring investors to expose themselves to greater risk. But effective diversification allows investors to reduce risk, by spreading their investments, while maintaining higher levels of return.

What is effective diversification?

Not all diversification is effective. Many investors buy a wide range of stocks in the belief that this will protect them from risk. The benefits of such diversification are likely to be insufficient if the stocks are all listed on the same exchange and selected using the same method. The entire portfolio will tend to rise and fall in unison — as in the well-known adage “a rising tide lifts all boats.” The key is to select stocks or investments that have low correlation.

What is correlation?

Correlation is the degree to which separate investments rise and fall together. Correlation measures the tendency of investments to advance or decline independently of each other. The correlation coefficient, identified by the symbol r, expresses the level of dependency between two variables (stocks in our case). Values for the correlation coefficient range from 1.0, for stocks that are perfectly correlated, to -1.0 for stocks that move inversely to each other.

Only two shares of the same stock, like BHP Billiton, are likely to have a correlation as high as 1.0. But stocks from the same sector are likely to share high values. And stocks from the same market are also likely to share a reasonable degree of correlation in larger time frames (i.e. the primary cycle).

You are also unlikely to find stocks that are the perfect inverse of each other — a coefficient of -1.0 — except possibly from an index ETF and its bear counterpart.

We are not necessarily looking for stocks with negative correlation, however, but stocks or investments with low correlation — closer to zero than to 1.0. As you can imagine, going long and short the same stock would protect you from any variation in prices, but would not deliver much in the way of return. If we had a spread of investments with low correlation (i.e low dependency) their price movements will tend to offset each other, providing a smoother portfolio return.

3 Ways to achieve diversification

We are likely to find investments with low correlation using three different techniques:

  • Diversification by asset class;
  • Diversification by geographic location; and
  • Diversification by strategy.

Asset class

There are a number of asset classes available to investors. Asset classes as diverse as stocks, real estate and fine art, however, are all subject the vagaries of the economic cycle and tend to rise and fall together.

Bonds tend to have low correlation to stocks. We need to make a distinction here between government bonds with low risk premiums, which fluctuate largely with the interest rate cycle and tend to be counter-cyclical (i.e negatively correlated) to stocks, and corporate bonds which are subject to far higher risk premiums that may expand and contract in line with the stock market cycle. Credit spreads tend to be low when the stock market is bullish and widen sharply during a contraction.

There are other asset classes such as insurance funds, where risks such as weather events tend to have low correlation to the economic cycle, but investors need a fair degree of expertise to assess the risks associated with these investments.

Geographic location

Australian investors tend to be highly concentrated in the Australian market, with only about 15% of assets invested offshore, both directly and indirectly through managed funds. Most major stock markets tend to rise and fall together, but diversification, especially to US markets, affords investors the opportunity to diversify into sectors not available on the local exchange.

By strategy

Diversification by strategy is often overlooked. If an investor, for example, diversifies their stock portfolio across several value-based fund managers they are likely to find that their investments rise and fall in unison. Even though the managers may hold a wide spread of stocks, they are all selected using a similar process and will tend to behave in a similar manner.

By spreading investments across several strategies, the investor is likely to achieve more effective diversification and more stable returns. Diversification between value-based strategies and our own momentum strategy is an obvious example. Recent research shows ASX 200 Prime Momentum has a low correlation of 0.3368 with the popular Perpetual Industrial Share Fund [PER0011AU] and moderate correlation of 0.4263 with Colonial First State Australian Share – Core [FSF0238AU].

Diversification is not the only “free lunch” available to investors — effective tax planning also enables investors to enhance returns without increasing risk — but it is important and should not be neglected. It is a complex area and we recommend that you consult your financial adviser before taking any action.

The best argument for mutual funds is that they offer safety and diversification.
But they don’t necessarily offer safety and diversification.

~ Ron Chernow

To sell or not to sell?

Recent acquisition Northern Star Resources [NST] in the ASX 200 portfolio is a great example of the conundrum faced by long-term investors when a new stock leaps out of the starting blocks. Profit-taking is evident from the tall shadows/wicks early in the week and in the decline of 21-day Twiggs Money Flow. Medium-term selling pressure suggests the stock is likely to retrace and give back some of the gains of the last two weeks. The temptation must be great to sell the stock and lock in profits of close to 30 percent.

NST

It is important, however, to stick to the plan. We are investing for a longer time frame in anticipation of much larger gains. There is no guarantee that any individual stock, including NST, will deliver. But I can guarantee you that they will not deliver long-term gains if you sell within the first few weeks.

Investors in S&P 500 stock Micron Technology [MU] faced a similar conundrum in July 2013. The stock had put in a good run from $9.00 before encountering profit-taking as it approached $15.00. 21-Day Twiggs Money Flow retreated below zero and the stock fell back to $12.50. Many investors would have taken this as a sign to get out.

MU July 2013

With hindsight, the decision to stay the course looks easy: support held at $12.50 and MU is now trading at $33.00. But I am sure that there were many investors who forgot their original plan and took profits at $12.50.

MU 2013/2014

….They just aren’t bragging about it.

Disregarding the big swing and trying to jump in and out was fatal to me. Nobody can catch all the fluctuations. In a bull market the game is to buy and hold until you believe the bull market is near its end.
~ Jesse Livermore

That’s all for today. Take care.

Growth or Income?

Most investors face a decision as to how much of their portfolio to allocate to growth investments and how much to income investments. The mind-set of many income investors is that they cannot afford the volatility of growth investments. The following example illustrates how income investors can use growth investments to protect their portfolio against inflation and enhance overall returns.

Growth investments, historically, have outperformed income investments, but at the expense of greater volatility. They are typically favored pre-retirement by investors with long time horizons who seek to maximise their capital on retirement. Other than improved performance, growth investments also generally receive more favourable tax treatment than fixed income, further enhancing after-tax returns. Income investments historically exhibit lower volatility and are favored by retirees for their consistent income, also by risk-averse pre-retirees who wish to reduce the volatility of their overall portfolio.

Historic Returns

These historic returns to Australian investors from 1981 to 2009 illustrate the differences in returns and volatility. Data was originally provided by AXA:

Asset class: Australian stocks Australian fixed interest International stocks Australian REITS Australian cash
Annualised return (%) 11.38 10.41 10.81 10.49 9.18
Inflation (%) 4.41 4.41 4.41 4.41 4.41
Real return (%) 6.97 6.00 6.40 6.08 4.77
Standard deviation 23.32 7.60 21.41 18.75 4.95

Not all investment strategies are likely to match the broad asset classes, but they are a good starting point for developing an investment strategy.

What the future holds

One thing about the future is certain: it is not going to match the past. It also is not going to match our projections. Without a magic crystal ball, the best we can do is adjust past performance for expected changes and hope we are not too far off course.

My own expectations are that we are entering a low inflation environment. Central banks, after the global financial crisis, are likely to be far more vigilant about rapid credit expansion and asset bubbles. I have therefore adjusted my inflation expectation down to 2.0%. I also expect that low inflation will have greater impact on fixed interest and cash and have adjusted their returns accordingly.

Asset class: Australian stocks Australian fixed interest International stocks Australian REITS Australian cash
Annual return (%) 9.00 7.00 9.00 8.00 5.00
Inflation (%) 2.00 2.00 2.00 2.00 2.00
Real return (%) 7.00 5.00 7.00 6.00 3.00
Standard deviation 25 10 25 20 5

These projections are no more than an educated guess and are used for illustration purposes only. Make your own projections, but understand that unrealistic projections will yield unrealistic results.

Investing for Income

We can now determine how much to allocate to income investments and how much to growth investments.

Take a retired investor whose objective is to earn $60,000 per year (after tax) from investments while protecting capital from inflation.

If he/she earns an average return of 7.0% p.a. on income investments at an average tax rate of 15%, with 2.0% inflation, we arrive at a net return of 3.95% and a required investment of $1.519 million:

Average return: 7.00%
Less tax at: 15%
After tax: 5.95%
Deduct inflation: 2.00%
Net return: 3.95%
Required income after tax and inflation: $60,000
Required capital (60,000 x 100/3.95): $1.519 million

Adding growth investments

If we recognize hedging against inflation as a long-term goal and not an immediate cash flow need, we can consider funding the inflation element of the portfolio with higher-yielding growth investments.

Income Component

First we calculate the capital required to meet current income needs:

Average return on income investments: 7.00%
Less tax at: 15%
After tax: 5.95%
Required income after tax: $60,000
Required income investment: $1.009 million

Growth component

Growth investments typically enjoy higher after-tax returns because of improved performance as well as a lower tax component — through capital gains concessions and franking credits on dividends (for Australian investors).

Average return on growth investments: 9.00%
Less tax at: 10%
After tax: 8.10%
Deduct inflation: 2.00%
Net return: 6.10%
Required income from growth investments ($1.009m x 2.0%): $20,180
Required growth investment ($20,180 x 100/6.1): $0.331 million
Total required capital: $1.340 million

Using growth investments to fund the inflation component reduces required capital to $1.340 million, a reduction of $179,000. Alternatively, if we invest the previously determined capital amount of $1.519 million, we should average close to $11,000 of additional income (after tax and inflation) each year. With higher inflation rates, the difference is even greater.

Remember that this example does not take into consideration your personal needs and circumstances. Also, taxation and investing for retirement are complex subjects and we recommend that you consult a professional adviser before making any decisions.