Bollinger Bands®

Bollinger Bands is a versatile tool combining moving averages and standard deviations and is one of the most popular technical analysis tools. 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 traders might use the Bollinger Bands for; these interpretations are discussed in the following sections: 

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

I. 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.

Possible Buy Signal

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

Possible Sell Signal

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

These potential 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, considered to be a more aggressive approach, a trader might 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 potential trigger to buy or sell short would occur. This might help reduce losses when prices breakout of the Bollinger Bands for a while. However, it could be argued that many profitable opportunities could be lost. To illustrate, the chart of the E-mini S&P 500 Future above shows many potentially missed opportunities. However, in the chart on the next page, the more conservative approach might have prevented many painful losses.

Also, some traders might exit their long or short entries when price touches the 20-day moving average. 

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

II. Bollinger Band® Breakouts

Basically the opposite of "Playing the Bands" and betting on reversion to the mean is playing Bollinger Band breakouts. Breakouts occur after a period of consolidation, when price closes outside of the Bollinger Bands. Other indicators such as support and resistance lines (see: Support & Resistance) might prove beneficial when a trader decides whether or not to buy or sell in the direction of the breakout.

The chart of Wal-Mart (WMT) below shows two such Bollinger Band breakouts:

Bollinger Band Breakout through Resistance Potential Buy Signal

A trader might buy when price breaks above the upper Bollinger Band after a period of price consolidation. Other confirming indicators might likely be used by the trader, such looking for resistance to be broken; this is illustrated in the chart above of Wal-Mart stock.

Bollinger Band Breakout through Support Potential Sell Signal

Similarly, a trader might sell when price breaks below the lower Bollinger Band. A trader might use other confirming indicators as well, such as a support line being broken; this is shown in the example above of Wal-Mart stock breaking below support.

This strategy is discussed by the man who created Bollinger Bands, John Bollinger.

Bollinger Bands can also be used to determine the direction and the strength of the trend. The chart below of the E-mini S&P 500 Futures contract shows a strong upward trend:

Bollinger Band Showing a Strong Trend

The chart above of the E-mini S&P 500 shows that during a strong uptrend, prices tend to stay in the upper half of the Bollinger Band, where the 20-period moving average (Bollinger Band centerline) acts as support for the price trend.

The reverse would be true during a downtrend, where prices would be in the lower half of the Bollinger Band and the 20-period moving average would act as downward resistance.

Bollinger Bands adapt to volatility and thus are useful to options traders, specifically volatility traders. The next page describes how traders might use Bollinger Bands to make volatility-based options trades.

III. Option Volatility Strategies

There are two basic ways a trader might trade volatility:

1. Traders try to buy options with low volatility in hopes that volatility will increase and then sell back those options at a higher price. 
2. Traders attempt to 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 might 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 might be used to trade volatility:

Potentially 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, could potentially be a good options strategy.

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

Potentially 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 might begin to consolidate and become less volatile. Hence, selling options when Bollinger Bands are far apart, potentially could be a smart options volatility strategy.

(Source: onlinetradingconcepts.com)