Bollinger Bands Strategy
A recurring issue when trading stocks or stock options is whether the stock in question is overbought or oversold. Traders commonly use moving averages to help with this dilemma. An additional tool that assists with the use of moving averages is the Bollinger band. Actually, there are two Bollinger bands, one above the moving average and one below. This technical analysis tool acts as a price envelope within which sits a simple moving average. Here are some thoughts about Bollinger band strategy as applied to trading options.
What Are Bollinger Bands?
Bollinger bands are a technical analysis tool developed by John Bollinger forty years ago. Bollinger devised this tool in response to the general realization that market volatility is dynamic and not static. This tool can be adapted to both short and long time frames. It is generally meant to be used to confirm other indices as opposed to being a stand-alone tool. Start with a basic moving average such as 50 days. Calculate the standard deviation of this moving average over its time frame. The upper and lower bands are placed above and below the moving average on a chart to provide a price envelope to indicate oversold and overbought conditions.
How to Use Bollinger Bands When Trading Options
Bollinger bands are an indicator and are generally used to confirm indications from other indicators. When volatility is low and the bands “tighten up” this increases the chances of prices moving briskly up or down. Very commonly there is a false move in one direction followed by a breakout trend in the other. And, when the bands separate widely this commonly indicates increased volatility and often points to the ending of a market trend.
When prices bounce between one band and the other you can use them like you use the moving average itself as price targets.
And, during strong trends up or down prices may tend to follow or slip outside of a band. How long this happens will depend on the strength of the trend. Movement back and forth across a band is generally interpreted as waxing and waning of the strength of a trend.
Bollinger bands are used in conjunction with moving averages which can be used as stand-alone indicators or, very commonly, in pairs.
Bollinger Band Limitations
Bollinger bands are a technical analysis tool that react to market changes and do not predict them. Used in conjunction with moving averages they “smooth out” day by day fluctuations but may miss more recent evidence included in market movement. As a lagging indicator, Bollinger bands should be used to confirm rather than to predict likely market movements. The originator of this tool suggested using it with at least two “non-correlated” indicators. In other words, don’t use this with another stand-alone moving average!
Additionally, this is not a “one size fits all” indicator. Depending on what stock or index you are trading, you may need to adjust the settings and adjust again until you have a system that works for you. This includes having to reset from time to time on the same stock or index when your results start to slip.
As with all trading indicators, by working with Top Gun Options you will learn which trading indicators to apply to which sorts of options strategies on which stocks or indexes. A word to the wise is that what you are seeing and interpreting from market indicators needs to make sense in the real world. These tools are not magic. They are basically a quick way to derive useful information from available market data. If you get too deep into indicators and move away from common sense your results will generally suffer. That is another reason to always hedge when trading options!