Bollinger Bands
Volatility bands that expand and contract around a moving average.
Bollinger Bands consist of three lines: a 20-period simple moving average in the middle, an upper band set two standard deviations above it, and a lower band two standard deviations below. The bands expand when volatility increases and contract when volatility decreases. Created by John Bollinger in the 1980s, they give traders a visual framework for understanding whether a stock's price is relatively high or low compared to its recent range.
Why It Matters
Bollinger Bands translate volatility into something visible on a chart. For options traders, volatility is everything — it drives premiums, strategy selection, and risk management. When the bands are wide, the stock is volatile and options are expensive. When the bands squeeze tight, volatility is low and options are cheap. This directly connects to implied volatility and helps you decide whether to be a buyer or seller of premium.
The bands also identify potential mean-reversion opportunities. Roughly 95% of price action falls within two standard deviations, so a stock touching the upper band is statistically extended and may pull back. A stock touching the lower band may be due for a bounce. This does not guarantee reversal, but it provides a statistical framework for trade selection.
How It Works
Default settings: 20-period SMA, 2 standard deviations.
Key concepts:
- Band touch is not a signal by itself. Price can ride along the upper band for days in a strong uptrend. A touch only becomes meaningful when combined with other confirmation like RSI divergence or a candlestick reversal.
- The squeeze: When Bollinger Bands contract to a narrow width, it indicates low volatility. Low volatility periods are often followed by explosive moves. Options traders watch for squeezes to buy straddles or strangles before the breakout.
- Band expansion: After a squeeze, the bands widen rapidly. The direction of the breakout — whether price exits through the upper or lower band — tells you the trend direction.
- Walking the band: In a strong trend, price can hug one band for an extended period. This is not overbought or oversold — it is strong momentum.
Options applications:
- Selling premium: When bands are wide (high volatility), sell iron condors or strangles using the bands as strike reference points.
- Buying premium: When bands are squeezed (low volatility), consider buying straddles or strangles to capture the coming volatility expansion.
- Mean-reversion trades: When price tags the upper band and shows reversal signs, a bear call spread may be appropriate. When price tags the lower band, a bull put spread.
Quick Example
A stock trades at $100 with a Bollinger Band squeeze — the bands are the tightest they have been in six months. You buy a straddle with 30 days to expiration, paying relatively cheap premium because implied volatility is low. A week later, the stock breaks out through the upper band to $108 on an earnings surprise. The call side of your straddle surges in value and you close it for a profit, while the put side loses less than expected because the move happened quickly.