Maximizing your Profits with Bollinger Bands

Bollinger Bands can help traders determine if a stock is overbought, oversold, or on the verge of a volatility increase

Nov 16, 2016 at 12:54 PM
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Prior to the recent presidential election, investors saw the market's "fear gauge" -- the CBOE Volatility Index (VIX) -- spike sharply, reflecting growing expectations for market volatility. To hone in on stocks or exchange-traded funds (ETFs) that could be on the verge of a big move, many traders utilize Bollinger Bands. Against this backdrop, I sat down for a Q&A with three of our best and brightest -- Schaeffer's Senior Equity Analyst Joe Bell, CMT, Senior Options Strategist Tony Venosa, CMT, and Senior Trading Analyst Bryan Sapp -- for the "inside scoop" on how to utilize this popular technical indicator.

How do you use Bollinger Bands?

JB: Bollinger Bands consist of a simple moving average with two volatility bands that are placed above and below the moving average, based on two times the standard deviation of the price. In practice, normally the wider the bands are, the more volatile recent price action has been, while the tighter the bands are, the lower the recent volatility has been. 

There are a lot of signals different traders utilize with this indicator, but there are three especially popular ones: when an equity's price goes above the upper band, a trader will often view that equity as being "overbought"; when the price goes below the lower band, a trader will often view that as being "oversold"; when the bands contract, and become very narrow, some traders use that as a signal that volatility may soon increase.

BS: I use Bollinger Bands as a signal to determine a period of potential volatility expansion. By nature, volatility is mean-reverting, so an extended period of low volatility will typically be met with volatility expansion, and vice-versa. So, as a straddle trader, I’m attempting to front-run the volatility expansion by using Bollinger Bands as a technical indicator to potentially signal that volatility has bottomed. 

What other indicators do you find to be most useful when used in conjunction with Bollinger Bands?

JB: There are many derivative indicators that people use to create signals from Bollinger Bands. One popular indicators is called the Bandwidth Indicator. It basically measures the width of the Bollinger Bands relative to the middle band. The calculation is simply the difference between the upper and lower band divided by the moving average. When the percentage becomes very low, traders may look for trades that profit from an increase in volatility. When the percentage becomes very high, traders may look for trades that profit from contracting volatility.

BS: I like to use the current Bollinger Bands' width, and overlay that with historical readings that have proven significant in the past. For example, a stock/ETF with a Bollinger Band width at or near an annual low (on a daily chart) is typically a good sign that something is about to happen to cause that stock to move violently. Often times, you’ll get Bollinger Band "pinches" ahead of an event like earnings, Fed meetings, etc. 

What are the advantages of using Bollinger Bands?

TV: There are two main advantages to using Bollinger Bands. First, they can be visually intuitive to the trader in aiding them to find situations where the Bollinger Bands are coming together, or almost pinching, which could be an optimal time to get ready for the stock to enter an expansionary phase. Another advantage is scans can be easily created among the different platforms available to traders out there. Bollinger Bands make it relatively easy to find situations where stocks are experiencing contractionary phases, which may signal the stock is ready to transition to an expansionary phase.

JB: It is an unbiased tool that allows the trader to visually see where price is at relative to the volatility of price. It also offers triggers for trades that may give the trader tools that are more mechanical when making buy/sell decisions.

When should a trader not use Bollinger Bands?

TV: Traders should shut off Bollinger Bands on trending stocks. I find no use for Bollinger Bands when stocks are in strong trending phases.

JB: There are times when a security can stay overbought or oversold for extended periods of time. That is why it is important to utilize other, different factors and different indicators to analyze a stock in combination with Bollinger Bands. In addition, a trader may have to adjust the buy/sell signals from the indicator depending on the security’s past signals. As with any indicator, it is always good to back-test and make any adjustments based on the security you are analyzing and the behavior of that security.

BS: The one big caveat for using Bollinger Bands is you must always check the news surrounding a stock before blindly entering a trade based on a Bollinger Band contraction. Stocks that are involved in M&A will oftentimes just churn sideways until the deal is complete, so there’s no real opportunity in those as a trader. Bollinger Bands must always be used within the context of the stock/ETF entering a period of volatility contraction that’s a result of normal market forces, and not news that’s waiting for a final resolution.

How do Bollinger Bands work within Schaeffer's contrarian strategies?

JB: Bollinger Bands are one of many technical indicators that can work with Schaeffer’s contrarian strategies. Schaeffer’s Expectational Analysis is made of three components: fundamental, technical, and sentiment analysis. This indicator would fall into the "technical" category. It can be used as a timing tool for entry and exit of trades. For example, a stock may be surrounded by extreme pessimism, but has strong and/or improving fundamentals, and is in the midst of a long-term uptrend. In the short term, a trader may see an oversold signal for the stock and use it has a timing tool to initiate a bullish position that fits the other criteria of the methodology.

Any recent examples of successfully using a Bollinger Band?

BS: Bollinger Bands are the first technical indicator that I look for when trying to find straddle trades, so many of our big winners in the Volatility Trader and Weekly Volatility Trader services are good examples.

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