You’ve probably heard the term, “what goes up, must come down.” That makes sense when gravity is considered, but what about asset prices? Is there a certain financial “gravity” that plays out for stock trades? Absolutely.

For financial assets like stocks, valuation is something that will eventually impact the price either positively or negatively. If a stock is at a point of extreme overvaluation the tendency is for the price to fall. If it’s undervalued, it tends to rise. The only problem with valuation is in the timing. When do you buy and when do you sell?

This is where technical analysis can be a great help. In this case, the price is examined not for valuation, but separation from the moving average. A strong period of detrending from historical averages makes the price primed for retracement and convergence with the average. This is the premise of the “Rubber Band Trade.” Let’s dive into the specifics.

Rubber Band Trade Indicators

There are various versions of the “Rubber Band Trade” out there. The foundational elements will be the same, but the indicators will be different. The version that I’m going to share is one that I’ve developed over the years.

Here are the components:

• Keltner Channel
• Stochastics RSI
• Aroon Oscillator

Keltner Channel

There are various measures for price volatility in trading. However, one indicator that doesn’t vary as wildly is the Average True Range (ATR). The concept of “true range” is that it accounts for price gaps that the daily range won’t account for. The ATR accounts for price gaps by taking the greater distance between the following:

• high and low for the period
• Previous day’s close to the next day’s high
• Previous day’s close to the next day’s close

By taking a 14-day average of these daily values, it gives a trader an idea of how much movement to expect daily.

When price swings from a support to resistance or resistance to support, it’s not uncommon to see swings of 2-3 times the ATR. In order to isolate more extreme movements, it’s necessary to take a multiple that is greater than three times the ATR.

An indicator that incorporates both the ATR multiple and a moving average are Keltner Channels. Keltner Channels incorporate an exponential moving average with volatility bands that are above and below the average. A common setting is a 20-period exponential moving average with 2 ATR volatility bands. However, remember that we’re looking for extremes.

For the purpose of this system, we’re using a 50-day exponential Keltner Channel with 4 ATR volatility bands. The ATR setting would be set to a simple average of the daily ATR.

Stochastics RSI

Relative Strength Index (RSI)

The RSI is a momentum indicator that considers the average gain and loss for a given look-back period. The root calculations for the RSI uses the following:

• Average Gain = Sum of gains over the past n periods / n
• Average Loss = sum of losses over the past n periods / n

If the price is experiencing more frequent and/or large moves up relative to the down periods, the indicator rises. If the stock is experiencing more frequent and/or large moves down relative to the up periods, the indicator will fall.

The RSI is also bound between 0 and 100, which makes it helpful for understanding overbought and oversold conditions for a Rubber Band Trade.

Stochastics (STO)

The STO indicator is a sentiment indicator that compares the closing price of a security to its range over a predetermined look-back period. If the price is closing in the upper end of its range for a given look-back period, the indicator will rise. If the price closes in the lower end of its range for a given look-back period, the indicator will fall. The STO is also range bound between 0 and 100.

Stochastics RSI (STO RSI)

The STO RSI incorporates both the RSI and Stochastics in a single indicator. Instead of using the price for the STO calculation, the STO RSI uses the RSI. Therefore, as the RSI closes in the upper end of its range, the STO RSI rises. If the RSI closes in the lower end of its range, it falls. Since the STO is bound between 0 and 100, it makes it possible to see when the RSI is reaching relative extremes on its own.

For this strategy, the RSI will be set to 10 periods. The STO will have a K-period value of 10, a D-period value of 3 and the slowing period set to 1. As part of this strategy, we’re looking for values above 90 for bearish trades and below 10 for bullish trades.

Aroon Oscillator

Before you can interpret the Aroon Oscillator, you have to understand the underlying indicator.

The Aroon Indicator consists of two lines, the Aroon Up and the Aroon Down. Aroon Up measures the number of days since the price has achieved a new high for a given look-back period. Aroon Down measures the number of days since the price has achieved a new low for a given look-back period.

For example, a 5-day Aroon indicator looks back at the prior days, and if a new high has not been reached over the prior 5 periods, the indicator will be at 0. If in the prior 5 days, the price had a new high 4 days ago, the indicator will have a value of 25. If the price hits a 5-day high, the indicator will be at 100.

The opposite is the case for the Aroon Down. If the high price was 5 days ago, the indicator will be at 0. If the price just hit a new high for the 5-day period today, it will be at 100.

The Aroon Oscillator just subtracts the Aroon Up indicator from the Aroon Down indicator. As a result, a value of 100 means the the Aroon Up is 100 and the Aroon Down is 0, and value of -100 means that the Aroon Up is at 0 and the Aroon Down is at 100.

For this strategy, the Aroon Oscillator will be set to 5 periods and the relevant values are the extreme readings of 100 for bearish trades and -100 for bullish trades.

Rubber Band Example

One area of the market that has been on fire is the pharmaceutical industry. Companies like McKesson Corp (NYSE: MCK) and AmerisourceBergen Corp (NYSE: ABC) have staged significant rallies over the past month. The result is that the current price is significantly above the 50-day moving average and outside of the Keltner Channel. The chart of ABC below is an example.

Yesterday the price closed above the upper Keltner Channel while the Aroon was pegged at 100 and the STO RSI had both lines pegged as well. This is a very extreme condition and one that may be an indication that the price is poised to converge with the 50-day moving average. Not only is the price at an extreme, but it also virtually rallied from the lower Keltner to above the upper.

Conclusion

It can be hard to identify stocks that are trading at extremes and it’s even harder to trade against the trend. The Rubber Band Trade is an example of a system that doesn’t trigger all that often, but when it does, it is very representative of extreme conditions. Combined with valuation and other considerations can make a winning combination.