Bollinger Band® Breakouts
Basically the opposite of "Playing the Bands" and betting on reversion to the mean is playing Bollinger Band breakouts. Breakouts occur after a period of consolidation, when price closes outside of the Bollinger Bands. Other indicators such as support and resistance lines (see: Support & Resistance) might prove beneficial when a trader decides whether or not to buy or sell in the direction of the breakout.
The chart of Wal-Mart (WMT) below shows two such Bollinger Band breakouts:
Bollinger Band Breakout through Resistance Potential Buy Signal
A trader might buy when price breaks above the upper Bollinger Band after a period of price consolidation. Other confirming indicators might likely be used by the trader, such looking for resistance to be broken; this is illustrated in the chart above of Wal-Mart stock.
Bollinger Band Breakout through Support Potential Sell Signal
Similarly, a trader might sell when price breaks below the lower Bollinger Band. A trader might use other confirming indicators as well, such as a support line being broken; this is shown in the example above of Wal-Mart stock breaking below support.
This strategy is discussed by the man who created Bollinger Bands, John Bollinger.
Bollinger Bands can also be used to determine the direction and the strength of the trend. The chart below of the E-mini S&P 500 Futures contract shows a strong upward trend:
Bollinger Band Showing a Strong Trend
The chart above of the E-mini S&P 500 shows that during a strong uptrend, prices tend to stay in the upper half of the Bollinger Band, where the 20-period moving average (Bollinger Band centerline) acts as support for the price trend.
The reverse would be true during a downtrend, where prices would be in the lower half of the Bollinger Band and the 20-period moving average would act as downward resistance.
Bollinger Bands adapt to volatility and thus are useful to options traders, specifically volatility traders. The next page describes how traders might use Bollinger Bands to make volatility-based options trades.
Next Page - Option Volatility Strategies
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