How to spot a trend in a volatile market

By Jim Jubak

In a volatile market that takes bellwether stocks up or down by 20% in a matter of days, it's hard to believe there's any true, underlying trend to the trading. But even in times of remarkable turmoil on Wall Street, there's a way to cut through the noise that dominates the day-to-day activity.

Technical tools called "price channels" give investors a way to distinguish among stocks that seem to be moving up but that are actually still caught in a downtrend, stocks that are stuck in a flat trading range, and stocks that are actually staging a meaningful rally.

More than that: In a volatile market, "channels" can show you how to swing trade for relatively short-term profits as market sentiment oscillates between hope and fear. "Channels" can show you how to limit losses on trades or in long-term positions. And they can even help long-term buy-and-holders by telling them when to add to positions at the lowest average cost -- and how to allocate scarce capital among "buy" candidates.

So let me tell you how channel tools work, why they're especially well-suited to the current market, and how to apply them to your own investment strategy.

Variety of flavors

Price channel tools come in a variety of flavors, but they all attempt to create a picture that contains a stock's recent price. The channel is bounded at the top by the stock's highs and at the bottom by its lows.

Here's how to access three price channel tools that are available on MSN Money:

• With any stock quote you obtain, click on "Charts" from the menu at the far left of the page. Once a chart appears, make sure you're on the "Price History" chart by selecting that option from the dropdown under "Chart" at the top.

• Click on "Analysis" at the top of the chart. (You won't see this header if you haven't selected "Price History" under "Chart.")

• Then highlight "Price indicators." Your choices will appear in a menu to the right.

The tools differ in the way they create those top and bottom bounds. For example, one of the easiest to calculate, the price channel, graphs the trailing 20-day high for the stock and the trailing 20-day low. A second tool on our site, the moving average envelope, draws the top of the channel a specified percentage (say 5%) above a specific moving average (say, the 20-day moving average). The last tool, Bollinger Bands, uses standard deviation, a measure of a stock's volatility, above a specific moving average (say the 20-day again) to create the top and bottom bounds.

The case for Bollinger Bands

All three have their adherents and their advantages. But I think Bollinger Bands work particularly well in the current market. This tool not only filters out the noise to show the price trend in the stock, but it also shows the trend in the stock's volatility. And that's especially useful for investors trying to limit losses and judge the probability of a top- or bottom-side breakout.

The easiest way to tell you what a chart with Bollinger Bands can show an investor is to work through a few charts.

Let's start with a chart for E*Trade (ET, news, msgs). (I'll be referring to a three-month price history chart for the stock with 10-day, 50-day, and 200-day moving averages, and Bollinger Bands drawn in -- all taken from a period around the start of 2002.)

You can see that you could have made decent money trading this stock over the three months by selling when it approached the top of the band -- at around $12 in early January, for example -- and buying at the bottom -- at around $8 or $9 in February. You would have completed another round trip on that trade in early March when the stock neared the top of the band at $10 or so.

The chart also prompts an investor with a longer-time horizon than a few months to ask some key questions. It's clear that the top of the band started to climb again in the first two weeks of March. At the same time the bottom of the band continued a gradual descent. The increased spread between the two bands indicated that the volatility of the stock's price was increasing -- the market was producing bigger swings in the price of E*Trade at that time.

But wasn't clear how that increased volatility would be resolved. Continued upside volatility -- in other words, a continued climb in price -- could push the stock and the upper bound higher. If that were accompanied by lower downside volatility (in other words, if the lower bound were to rise and the gap between top and bottom were to narrow), then the chart would indicate that E*Trade was on its way to a steady recovery.

As it is, though, the chart says it was just too soon to tell.

Don't get pinched by volatility gap

Contrast this with the chart for American Express (AXP, news, msgs). Here the stock broke through the top of the band decisively near the end of February 2002 -- and kept on going. At that time the volatility gap of the Bollinger Band had narrowed significantly, establishing a decent base for a move up.

But this chart too raises a question for investors. The strong move up created a huge volatility gap on the chart that was a visual representation of investor psychology at the time. After a strong climb like that, investors, who knew that the stock was at $34 just weeks before, started to think about taking profits. And some actually did. That put the brakes on the stock's climb and worked to close the volatility gap, setting up American Express for a consolidation of gains.

If you're a fundamental investor, you might be feeling uneasy right about now with all this talk about charts and price trends. I certainly understand that reaction. Fundamentally, I'm a fundamentalist. Over the long run, I believe that fundamentals such as earnings growth, return on invested capital, and a company's cost of capital determine a stock's price.

But I don't see any point in being a purist about my fundamentalism if it's going to cost me money. If the tools of technical analysis offer insight into the behavior of the market, it seems silly not to take advantage of the information. And in this market, technical tools such as Bollinger Bands are a quick way to track the ebb and flow of investor psychology.

Whenever investors are torn between hope and fear, it's a good opportunity to use "price channel" tools. But this tool is also useful for investors who aren't short-term traders. Long-term buy and holders can use price channels to time their buys to keep their average basis costs lower as they build positions, for example.

The tool is also a good way for anyone slowly stepping back into this market to avoid buying at the top of each swing of the market and then selling in panic at the bottom of each countermove. It is easier to keep your head when you know that those extremes are just part of business as usual in this market.

And finally, I think studying the price trend after a price channel tool has filtered out some of the noise of this very volatile market is a good way to prevent yourself from running too far ahead of the trend on individual stocks and individual sectors.

Editor's Note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that Jubak's Picks recommendations are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.

E-mail Jim Jubak at jjmail@microsoft.com.

At the time of original publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Apache, Citigroup, E*Trade Group and Intel. He does not own short positions in any stock mentioned in this column.