Bollinger Bands

Bollinger Bands is a versatile tool combining moving averages and standard deviations and is one of the most popular technical analysis tools available for traders. There are three components to the Bollinger Band indicator:

1. Moving Average: By default, a 20-period simple moving average is used.
2. Upper Band: The upper band is usually 2 standard deviations (calculated from 20-periods of closing data) above the moving average.
3. Lower Band: The lower band is usually 2 standard deviations below the moving average.

Bollinger Bands (in blue) are shown below in the chart of the E-mini S&P 500 Futures contract:

 

There are three main methodologies for using Bollinger Bands, discussed in the following sections:

1. Playing the Bands
2. Bollinger Band Breakouts
3. Option Volatility Strategies

Playing the Bollinger Bands

Playing the bands is based on the premise that the vast majority of all closing prices should be between the Bollinger Bands. That stated, then a stock's price going outside the Bollinger Bands, which occurs very rarely, should not last and should "revert back to the mean", which generally means the 20-period simple moving average. A version of this strategy is discussed in the book Trade Like a Hedge Fund by James Altucher.

Buy Signal

In the example shown in the chart below of the E-mini S&P 500 Future, a trader buys or buys to cover when the price has fallen below the lower Bollinger Band.

Sell Signal

The sell or buy to cover exit is initiated when the stock, future, or currency price pierces outside the upper Bollinger Band.

These buy and sell signals are graphically represented in the chart of the E-mini S&P 500 Futures contract shown below:

More Conservative Playing the Bands

Rather than buying or selling exactly when the price hits the Bollinger Band, the more aggressive approach, a trader could wait and see if the price moves above or below the Bollinger Band and when the price closes back inside the Bollinger Band, then the trigger to buy or sell short occurs. This helps to reduce losses when prices breakout of the Bollinger Bands for a while. However, many profitable opportunities would be lost. To illustrate, the chart of the E-mini S&P 500 Future above shows many missed opportunities. However, in the chart on the next page, the more conservative approach would have prevented many painful losses.

Also, some traders exit their long or short entries when price touches the 20-day moving average. This was the methodology used for going long in the book Trade Like a Hedge Fund.

A different, and quite polar opposite way to use Bollinger Bands is described on the next page, Playing Bollinger Band Breakouts.

Option Volatility Strategies

There are two basic ways to trade volatility:

1. Buy options with low volatility in hopes that volatility will increase and then sell back those options at a higher price.
2. Sell options with high volatility in hopes that volatility will decrease and then buy back those same options at a cheaper price.

Since Bollinger Bands adapt to volatility, Bollinger Bands give options traders a good idea of when options are relatively expensive (high volatility) or when options are relatively cheap (low volatility). The chart below of Wal-Mart stock illustrates how Bollinger Bands can be used to trade volatility:

Buy Options when Volatility is Low

When options are relatively cheap, such as in the center of the chart above of Wal-Mart when the Bollinger Bands significantly contracted, buying options, such as a straddle or strangle, might be a good options strategy.

The reasoning is that after sharp moves, prices tend to stay in a trading range to rest. After prices have rested, such as periods when the Bollinger Bands are extremely close together, then prices usually will begin to move once again. Therefore, buying options when Bollinger Bands are tight together, might be a smart options strategy.

Sell Options when Volatility is High

At times when options are relatively expensive, such as in the far right and far left of the chart above of Wal-Mart when the Bollinger Bands were significantly expanded, selling options in the form of a straddle, strangle, or iron condor, might be a good options strategy to use.

The logic is that after prices have risen or fallen significantly, such as periods when the Bollinger Bands are extremely far apart, then prices usually will begin to consolidate and become less volatile. Hence, selling options when Bollinger Bands are far apart, potentially could be a smart options volatility strategy. This strategy is further outlined in The Volatility Course by George A. Fontanills.