Timing for options trades relies on many price signals and confirmation. Even so, knowing when trends are likely to continue or to end is a skill of its own and many traders have timed entry and exit poorly because the trend was misread. One signal helps overcome this problem.
Bollinger Bands (BB) track the trend with three bands. The middle band is a of 20 sessions, and the upper and lower bands are each two standard deviations of that average. This sets up a great visual, forming a “probability matrix” of both price and trend.
Because price is not likely to trade above the upper band or below the lower band for very long, any move outside of this matrix is likely to be followed by a retreat back into range.
However, BB is not just a price-specific analytical tool. It also sets up a version of resistance and support as a dynamic factor rather than the traditional straight line. The chart of the Nasdaq 100 Index shows this relationship between the upward-moving trend and resistance.
It is possible to draw straight lines to identify resistance or support as well as times of breakout. BB tends to provide a dynamic version, which is more accurate and more predictive. As the price trend is upward-moving, the upper band tends to track resistance with extreme accuracy. And as a trend moves downward, the lower band tends to track support
In the NDX chart, three examples of the relationship between the upper band and the dynamic price movement are circled. The most revealing aspect of this is how accurately the band points to both entry and exit. As the price moves close to the upper band, it marks the beginning of a strong move. This is seen in all three of the highlighted examples. These are highly reliable entry points for trades such as long calls or short puts.
The ends as price moves away from the upper band. This is also seen clearly in all these instances on the chart. Logically, this marks an exit point, but not necessarily the start of a move. Unlike most reversal signals, the move of price away from the upper band signals only the end of the price move. The next phase could be resumption of the trend, retracement, or reversal. To decide, requires a new set of signals.
The interaction between the bands and identification of the trend also works when a dynamic trend ends and moves into a period of consolidation. This occurred at the beginning of December. Notice how strongly the band width narrows, going from 600 points in beginning November down to under 250 points. This shrinking band width signals a likely period of consolidation, which serves as a rest between dynamic trends, a plateau before trend resumption or reversal. This also points to the timing for a different type of option trade, which exploits a range-bound tendency in the short term. In fact, consolidation may be the most profitable trend for short-term trading because breakout is easily identified. Look for a widening of the band width to anticipate a new dynamic move. It does not matter whether that will be or ; the issue is that a widening band width signals likely end to consolidation.
Entering a consolidation-type trade like an Iron Condor (with strikes far outside the band width), a short covered straddle, are well-timed as consolidation begins, but should be closed as consolidation ends. At that point, a new trade can be opened to exploit dynamic price movement, such as synthetic stock (long or short) or simply a long option.
The issue to keep in mind in all of these timing decisions is that BB provides more than a reliable tracking device for price. It also marks the nature of short-term trends, whether dynamic or sideways-moving. It is one of the most reliable predictive signals options traders can find.
I'm uncomfortable with BBs because I don't know when to use the touch of a band as a signal to sell (it reached an extremity of the dynamic range), or to buy (it signals the start of a trend).
Similarly, I don't how how to use the middle band (MA20) : is it time to buy (good value) or to sell (price dumping) ?
I'm told I should use another indicator to decide on that, but then I'm not sure what the BBs should be used for.
The middle band is just a simple moving average and can be traded and interpreted as you would any SMA. For example, if price is bouncing off the middle band, you can use it as an entry. You can also use the middle band as a stop loss and trail the stop loss based on the current position of the SMA. For example, you are long and price is trading above the middle band. Price then pulls back, you can set a stop loss slightly below the middle band. If price bounces off the middle band and continues to move higher, you're still in the trade. If it crosses the middle band, your stop loss takes you out before it continues to the lower band.
Bollinger Bands are excellent when used with other technical indicators. Stochastics and the Awesome Oscillator are two indicators which, when aligned to price trading at the extreme sides of the Bollinger Band, can be used to signal a directional bias alignment. For example, trading outside of the upper Bollinger Band, red AO, and Stochastics crossed down would all be an alignment for a declining bias.
I hope this helps.