What are Bollinger bands?
Bollinger bands represent a two-standard deviation trading range that is distributed around the 20-day moving average. The width of the trading range is based on the historical volatility of a given stock. When volatility increases the bands will widen. Similarly, the bands contract when volatility takes a breather.
Bollinger bands can be used across all asset classes but it is especially useful for option investors and traders. The technical analysis tool can help an investor determine when an option chain is expensive (i.e high volatility) or when it trades at a discounted price (i.e low volatility).
How to use Bollinger bands to trade options?
By placing more emphasis on the most recent volatility patterns, an options price reflects specific trading ranges around a given point in time. Armed with this information, an investor can better determine an appropriate options strategy.
Option investors can buy call options and profit if the underlying stock moves higher. On the other side of the trade, a put option typically gains in value should the underlying stock move lower. Which option an investor decides to buy will depend on their analysis of the stock, and Bollinger bands can assist with this.
- If the stock is trading near the lower end of the Bollinger band, one would expect the stock to move higher so buying a call option would be more appropriate.
- If the stock is trading near the higher end of the range, one would expect a reversal and buying put options could lead to a profitable trade.
How to create an options trading strategy using Bollinger bands?
Consider the example below using the iShares S&P/TSX 60 Index ETF (TSX:XIU) as of August 15, 2022. As we can see, the current price of $30.85 is trading very close to the high end band of $31.04 while the low end band is $28.50 .
Based on the logic above, investors would consider buying put options and perhaps target the low-end band as an exit point.
Bullish traders may want to consider entering a covered call writing trade or bullish put spreads. The Bollinger bands would be implying a change in trend. But at the top end of the range, a more cautious option strategy would be most applicable.
In the middle of the range, bullish traders should also lean towards strategies such as covered call writing or selling cash secured puts.
If the ETF were to move closer to the middle of the band range, investors should consider writing bear call spreads. Doing so implies selling call options with a strike price at the top band while simultaneously buying a call option at one or two strikes above that.
Integrating Bollinger bands into your trading toolkit
Bollinger bands are a great tool for investors of all shapes and sizes because of the easy-to-understand logic. Not only is it easy to understand, the bands are set to two standard deviations which implies more than 90% of the trading action takes place between the upper and lower bands.
While this gives investors a great starting point to evaluate a trade, it is not a perfect science. Option investors that are able to understand Bollinger bands and combine the information gathered with other analytical tools are more likely to enter into a profitable trade.
Disclaimer:
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
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Key takeaways
- Once the Bollinger band tightens (i.e. after volatility eases), the stock could see a sharp price change.
- When a stock price moves outside of the band range, we would expect to see a continuation of the current trend.
- Bottoms and tops recorded outside of the range followed by bottoms and tops inside the range implies the potential for a reversal in trend.
- A move that starts at one band could move all the way to the other band.