Bollinger Bands Grow Tighter

11/07/05 01:57:52 PM

by David Penn

Contracting Bollinger Bands on a weekly chart of the 10-year note yield suggest the potential for greater volatility in the near term.

Security: $TNX
Position: N/A

"And I hope it's a sweet ride
Here for me tonight
Cause I feel I'm go-ing
Feel I'm slow-ing. Down."
--Soundgarden, "Tighter and Tighter"

Having written so much about breakouts of Bollinger Bands in recent weeks, it is interesting to turn to a weekly chart of the 10-year Treasury note yield ($TNX) (Figure 1) and find the most important technical feature of that chart to be Bollinger Bands that are not only largely containing price action, but appear to be constricting it.

Of course, it is price that is constricting the Bollinger Bands, not the other way around. But a sense of the Bollinger Bands growing tighter in this weekly chart might be helpful in imagining what the end result of this tightening is likely to be: namely, an explosive move to the upside or downside, taking $TNX toward 5% or back down below 4%.

FIGURE 1: WEEKLY 10-YEAR TREASURY NOTE YIELD. Bollinger Bands that are becoming increasingly narrow contain the range-bound yield of the 10-year Treasury note. Tightening Bollinger Bands are often a sign that volatility may be dropping below normal, or historical levels. As such, a return to normal volatility -- and perhaps an explosive return -- is something that traders should be wary of.

Graphic provided by: Prophet Financial, Inc.

Writing his excellent technical analysis primer, The Visual Investor, John Murphy notes the following about Bollinger Bands:

The Bollinger bands ... are constantly contracting and expanding in order to adjust to market volatility. Volatility refers to the degree of movement in prices. The bands will contract during periods of low volatility and expand during periods of high volatility. You can track the width of the bands to determine market volatility. Unusually narrow bands (reflecting low volatility and a quiet market) are usually followed by a period of high volatility (rapid and substantial price moves) ...

The decrease in volatility can also be seen plainly in Figure 2, which includes historical volatility in both 10-day and 100-day studies. In both instances, historical volatility has been trending downward since late in the third quarter of 2003.

FIGURE 2: DAILY 10-YEAR TREASURY NOTE YIELD. Since the top of the spike in $TNX from the summer of 2003, historical volatilities in both 10-day and 100-day increments have been trending decidedly downward.

Graphic provided by: Prophet Financial, Inc.

It is important to remember that any near-term "period of high volatility" could be to the downside as well as the upside. Volatility means just that. Nevertheless, traders have an abundance of other tools that can be used to anticipate the direction of any break in prices -- to say nothing of methods that will allow them to swiftly join the directional party as soon as prices make their intentions clear.

FIGURE 3: DAILY 10-YEAR TREASURY NOTE YIELD. The abundance of positive MACD histogram bars in the autumn of 2005 suggest that $TNX�s course marks the path of least resistance. The fact that the 10-day EMA (in red) remains relatively close to trailing lows suggests that the $TNX has yet to become especially overextended to the upside.

Graphic provided by: Prophet Financial, Inc.

Although increasingly ripe for a pullback, the $TNX in the daily chart in Figure 3 may be overbought, but not necessarily so overextended to demand a dramatic correction or pullback. While pulling away from the 50-day EMA, the fact that the 10-day EMA continues to provide support just beneath the lows as the market moves higher is supportive. Even if $TNX did pull back, there is reason to believe that such a pullback would be contained by support near the 44 (or 4.4%) level. This level marks both the early August peak of the rally that began in June, as well as the pullback low during the brief correction in mid-October.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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