Bollinger Bands represent a very popular indicator of price volatility, offering traders a way to quickly understand how much an asset price is moving at a given time. There are ways to trade options with Bollinger Bands, and today, we’ll tell you more about it. Let’s look at how Bollinger Bands strategies can work on different occasions based on your risk tolerance.
Key takeaways
- A Bollinger Bands strategy is a trade setup that lets you profit from changes in price volatility. You can use the Bollinger Bands technical indicator to trade stocks, options, and any derivative contract.
- Bollinger Bands help identify overbought and oversold market conditions, providing traders with actionable insights.
- Bollinger Bands are effective for both trending and range-bound markets but must be used with caution during volatile periods.
What Are Bollinger Bands?
Before we look into specific Bollinger Bands strategies with options, let’s break down their structure. At the core, a Bollinger Bands strategy relies on three components: the upper band, the lower band, and a simple moving average (SMA), and this indicator looks as follows:
As you see from the image above, these bands are plotted two standard deviations away from the SMA, which is positioned in the middle. Here is what you should get from the picture above:
- Upper Band: Indicates overbought conditions when prices consistently touch or exceed it.
- Lower Band: Signals oversold conditions when prices frequently hit or drop below it.
- Simple Moving Average (SMA): Acts as the central trend line, smoothing out price data to create a clearer picture of market movements.
If you understand how to use Bollinger Bands, seemingly random market swings will often start to make sense to you. With this in mind, let’s get more practical in the section below.
How to Approach a Bollinger Bands Strategy
So, let’s move from theory to practice and explore how to effectively implement a Bollinger Bands strategy in your trading. We’ll begin by examining how to use Bollinger Bands for both identifying overbought and oversold stocks and how they play a pivotal role in different trading setups. In fact, here is a table comparing the different Bollinger Bands strategies discussed below:
Trade Overbought and Oversold Stocks (Backtested Approach)
When stocks trade beyond their Bollinger Bands, they often revert to the mean. Our study (see link at the bottom of the article) suggests that prices above the upper band for three days typically indicate a slowdown in bullish trends, often followed by a downturn in the next fortnight. Conversely, prices below the lower band for the same period tend to rise.
To trade this idea, you could evaluate some of the strategies below (that you may find on our screener for options):
- Credit Strategy: Offers a higher probability of profit than initial options pricing suggests, though potential losses can outweigh gains.
- Debit Strategy: Provides better average profits over losses, contrary to its predicted probability, making it a solid Bollinger Bands strategy.
- Broken Butterflies: This strategy requires minimal stock price movement for profits, it can come with a high-profit ratio, and you may use it to eliminate upward or downward risks depending on the use of calls or puts.
You can check the link at the bottom of the text for a working example and gain access to our free backtesting file.
Trading Bollinger Bands Squeeze Phases
The squeeze strategy involves watching for narrowing Bollinger Bands, signaling low volatility and potential breakouts. During these phases, traders anticipate significant price movements as the bands expand.
Let’s look at the NVDA example below:
We highlighted two boxes in the chart above:
- The red area shows you a moment in which NVDA’s price moved sideways. This phase is called a “squeeze,” since the Bollinger Bands are very narrow.
- The purple area shows how the bands widened as NVDA’s price broke up and formed a strong uptrend.
How could you trade these “squeeze” phases? Here are some ideas:
- If you think the squeeze phase is ending, then you could think about a long straddle (buying an ATM call and put), which can profit from significant movements in either direction.
- If you think the squeeze phase will continue, then you could consider an iron condor (selling an OTM call and put spread), profiting from sideways movements.
There’s no unique recipe, and what we’d do here is to paper trade and backtest different strategies on NVDA’s chart. But that’s something to consider: these squeeze phases may offer you excellent opportunities to enter a trade.
Finding Supports and Resistances with Bollinger Bands
Bollinger Bands can help identify support and resistance levels. The bands often act as dynamic support and resistance, adapting to the volatility and movement of the stock price. Specifically, here is how this logic works:
- Lower bands serve as support when prices approach from above.
- Upper bands act as resistance in upward trends.
In fact, let’s look at an example on GOOGL:
We have highlighted the cases in which the bands acted as supports and resistances. Specifically:
- The purple circles highlight cases in which the lower band acted as support. You can see how prices bounced up after touching this level.
- The green circles coincide with when the upper band acted as resistance, causing a pullback in prices.
How could you trade these cases with options? For instance, a debit spread (a bear put spread when resistance is identified or a bull call spread when support is found) could be a viable strategy, and it will cost you less than buying a single option. Note that, even though these bands act as resistances and supports, trends can sometimes break outside of the bands, so always have a stop loss in place.
By observing how prices interact with these bands, traders can anticipate potential reversals or continuation movements.
How to Use Bollinger Bands for Day Trading
Bollinger Bands are equally effective for day trading, especially with 0DTE (zero days to expiration) options, which expire by the end of the trading day. This form of trading demands precision and an understanding of rapid price changes.
How could you use Bollinger Bands for day trading? In summary:
- Employ strategies like those mentioned above, adjusted for shorter time frames.
- Consider using 0DTE options, which are ideal for traders comfortable with high risk, and seeking quick gains.
- For more conservative strategies, options with several days to weeks before expiration are suitable.
We can give you a quick example below. Suppose it’s Friday, and TSLA’s price is behaving as follows:
Observe TSLA’s price behavior in the highlighted period (see the red box), and you’ll notice it traded within a low-volatility range, indicated by tightly grouped Bollinger Bands. This scenario is ideal for implementing strategies that capitalize on minor price fluctuations, such as the iron condor with options expiring on the same day.
As the price exits this range, a 0DTE credit spread becomes an interesting idea to consider:
- For a bearish trend (price breaks downward, just like in the purple box highlighted in the chart), a bear call spread is suitable.
- Conversely, had the trend been bullish (price breaks upward), a bull put spread would have been more appropriate.
By employing these Bollinger Bands strategies, you can profit from both stable moments and emerging trends in TSLA’s market movement, effectively managing risk while capitalizing on different phases of price activity.
This setup offers traders a chance to enter the market just before a major breakout, aligning with the Bollinger Bands strategy for maximum impact.
When Can Bollinger Bands Work (and When They May Not)
You saw all these Bollinger strategies, but we feel we should add a word of caution here. The fact that there are so many ways to trade Bollinger Bands does not mean they work perfectly in every scenario. Understanding when a Bollinger Bands strategy is effective is crucial for successful trading.
When Bollinger Bands Strategies Work
Bollinger Bands excel in trending markets, helping traders identify overbought or oversold conditions. This can be especially useful in Bollinger Band trading for spotting potential price reversals. In a sideways market, they often highlight price boundaries, signaling potential entry and exit points. Day traders find value in these bands as they provide quick insights on short-term price fluctuations.
When Bollinger Bands Strategies May Not Work
However, Bollinger Bands can produce false signals, particularly in volatile markets where prices move erratically. During such times, bands widen, and the effectiveness of a Bollinger Bands strategy may diminish, leading to potential losses.
Challenges with Bollinger Bands:
- False Breakouts: Prices may breach the bands and quickly reverse, misleading traders.
- Rapid Volatility Changes: Quick expansions or contractions can make it hard to gauge true price direction.
Enhancing Accuracy with Other Indicators
To improve accuracy, consider combining Bollinger Bands with other technical indicators. This approach offers a more comprehensive view of market conditions.
- Relative Strength Index (RSI): Helps confirm overbought or oversold conditions.
- Moving Average Convergence Divergence (MACD): Offers insights into trend direction and momentum.
- Volume Indicators: Provide context for price movements within the bands.
Using these tools can help you get a better grip on how to use Bollinger Bands for day trading (or for any type of trading you have in mind), cutting down on false alarms and boosting your strategy.
Read More
Using Bollinger Bands in Options Trading – Part 1
Using Bollinger Bands in Options Trading – Part 2
