Using Bollinger Bands™ for Long Call and Long Put Buying...
The use of Bollinger Bands (BB) is a popular technique for finding investment opportunities. The Bollinger Band (BB) technical charting technique is based on stock price movement, and does not directly take into consideration the fundamentals of the stock. Technically BB is a measure of relative stock price movement, with bands of lines forming an envelope around the moving average of the stock price. A median line is generally shown in the center between the 2 bands representing the moving average of the stock price. One Bollinger Bands line is located above the moving average of the stock price and is used to indicate statistically where 95% of the stock prices should not exceed and one line below the moving average indicates statistically where 95% of the prices should not fall below. The bands are formed by adding and subtracting two standard deviation calculations of price from the moving average of the stock. Prices are relatively high when close to or above the upper band and relatively low when at or below the lower Bollinger Band. Although the bands formed are statistically based, they are not considered statistically rigorous. Statistically the time periods are too short and stock prices do not have normal distributions. Even with its statistical limitations BB analysis provides a valuable tool to help analyze stock price movement.
One of the most popular presentations of Bollinger Bands is the use of a 20-day period of time for the stock to determine the bandwidth of 2 standard deviations around the 20-day moving average. The bands widen during periods of increased volatility and tend to contract when volatility decreases. During the month of October the bands for Simple Tech Inc. (STEC), as shown, are very narrow during the months of September, October and half of November and then widen after the breakout, which occurs on November 20th. The STEC stock had favorable financials and an analyst meeting at the end of November, which was followed in early December with an upgrade of the entire Semiconductor industry by a major Broker and a bullish Mention by The Motley Fool. As a result of the news, the entire Semiconductor industry received more attention and the Bollinger Bands widened as the volatility increased considerably.
STEC daily stock prices with overlaid Bollinger Bands:
Generally one would expect the stock price to remain between the bands most of the time. A break out of the bands generally occurs when the stock price moves higher than the upper band or stock price moves lower than the lower BB driven by some event. The favorable news on STEC was an example of such an event. It should be noted the breakout occurred with increased volume and was supported by an increase of On Balance Volume (OBV).
Bollinger Band breakouts (BB BO) happen for many reasons that may or may not support a particular trading process. Examples of events that can cause a BO are:
An earnings surprise
A new product announcement
Stock buy-back announcement
Merger or acquisition announcement
A general economic event, like a rate change by the Federal Reserve
A shocking world event like 9/11
There are several different ways to look at a Bollinger Bands:
An unexpected event happened, which caused the price of the stock to change. This event may not be specific to the stock in which case the stock is expected to return to normal movement at some point. The last two events above are examples of general market or world not specific to a stock.
An event occurred related to this stock, causing it to have a change in price movement for some time. This breakout is the first sign of change, which can be expected to persist. The top four examples from the list are indicative of events that are stock specific.
Rather than looking for a Bollinger Band break out some investors use the width of the band as a means of measuring volatility. When looking at Bollinger Band width, a small distance between the bands occurs during low volatility (The Squeeze) and conversely wide bands occur during periods of high volatility.
A trading process, which takes advantage of the break out, must identify if it is a type one or a type two because they expect eventual movement in opposite directions. As an example, if the price movement of the stock were to break above the top band, a type one event would encourage us to buy a PUT option expecting the stock would fall in price as it returns to normal movement. However, if the stock broke the band as result of a type 2 event, such as a positive earnings forecast, we would consider buying a CALL option. The CALL option purchase would be considered since the upward price movement is expected to continue for some time.
The remainder of this article will focus on the Type 2 break out, where the stock price is expected to ride along the top band for some time. A method of trading options on a Bollinger Band breakout (BO) of this type might use a process like:
Use a Chart with Bollinger Bands period 20 days and Std. Dev. 2
Enter a CALL options position when the upper band is violated or a PUT position when the lower band is passed
Select an option with an expiration 3 months or more out in time & use the first strike Out of The Money (OTM)
Use at most 4 to 5% of total capital in each position
Be prepared to risk the entire position each time
Hold the position until:
20-day moving average (20 DMA) is violated (sell it all)
Sell half when position is worth 4X, keep selling half every 4X
The trading process listed above works best when the band is broken because the stock is on a new or changed path (Type 2). Events related specifically to the stock are the most important. General market changes are only important to support the direction of the trade, otherwise, the general market event would tend to be very short term. In a general market event (Type 1) the stock would be expected to revert to the norm. The breaking of the band highlighted in the above trading system assumes the change in path will continue long enough to make the option go ITM and, therefore, profitable. The position is then liquidated when the stock returns to the norm or median price. In the above process, the option is sold when the stock closes below the moving average. If the stock movement reverts back to the norm too quickly the trade will not be profitable for this type of investment position.
When this trading system was presented at the expo, there was no distinction made between a type 1 or 2 breakout. Clearly the method favors type 2, but there was no discussion on how to distinguish between a type1 and 2. At the Expo the presenter was more focused on the management of the position to correct false breakouts and assumed that you only needed to be correct one in four times to be profitable over the long run. In general, the management of the position will be very important to profitability, but the process can be greatly improved if the stock picked has other attributes that support the direction of the position taken. The above trading process will have many failures, but those trades that are successful, will have very large gains. Hopefully the gains more than make up for the frequent false BO losses.
Many traders using a Bollinger Band methodology will look for some other supporting evidence before initiating the trade. An example of a supporting event would be substantial increased volume for the stock or increased volume with the breakout of an important support or resistance zone. Just as Bollinger Bands create a relative framework for the price of a stock, many investors use volume as a % compared to the last several months provides a framework for comparing relative volume. Volume use in this way can be a strong supporting factor of a BB BO. Or look for supporting evidence from an on balance volume indicator (OBV), which looks at volume on up days vs. volume on down days. Another example would be breaking a new high or low for the stock over the last year. The Investors Business Daily (IBD) system of trading uses the new price high accompanied by high volume technique, which would be an additional supporting factor rather than using a BB BO technique by itself.
How would this trading system have worked out with STEC in the above chart? STEC stock broke out on 11/20/07 at the close on increased volume and an upward trending OBV. The Feb 7.5 Call could have been purchased the next day at about $0.80 per options contract. If 5% of our capital was $4,000 we could have purchased 50 contracts of the Feb 7.5 calls (SQRBU) at 80 cents per contract. And we would hold the position until the 20-day moving average was violated, which would be set at about 6.80 in this case at the start. The 20-day moving average will increase in price as the stock rises and act as a trailing stop for the position. In this case the stock initially rose so fast that the 20 DMA continued to lag behind as we went into the first few weeks of December. The 20 DMA rose to over $8 per share by December 6th. But on Friday, December 7th the option rose to over $3.30 and triggered the selling of one-half the position since the price went over 4X our original purchase price ($0.80 x 4 = $3.20). Therefore, we would have sold 25 contracts at about $3.20 for a profit of ($3.20 - 0.80) x 2500 = $6,000 in a time span of only 12 trading days. At this point we would have gotten back our initial investment of $4,000 and made a $4,000 profit (100%). And would still be holding 25 contracts, which would be sold if the 20 DMA were violated.
On the following Monday, December 10, 2007 the stock closed at a price of $10.25 (-.57) with above average volume. The 20 DMA was at $8.19, more than 2 points under the fast moving stock. This sell off was precipitated by a Brokerage house downgrade from a buy to neutral rating. Undoubtedly the downgrade was caused by the rapid rise in the price of the stock to the point where valuation was a concern. A point to reflect on at this juncture is that our purchase was purely technical in nature, based only stock price action and our sell points are also technical based on stock price without regard to these fundamentals.
Note that a turning up of the lower band often signals an end to the short term run in the stock. By December 11th the lower band is starting to move up, indicating that this run may be at an end. Only time will tell if this is a temporary consolidation or truly an end to the run. Most short-term traders would probably exit the position at this point. However, this sell-off happened with relatively low volume, which did not confirm the loss of momentum and our plan called for an exit only if the 20 DMA was violated. On 12/17/07 the 20 DMA stop was at $9.01 and the stock closed at $9.52.
Our sell signal came on 12/18/07 when STEC closed at $9.08 and the 20 DMA was at $9.25. The stock was down $0.29 for the day and also went down on increased volume. Both of these events were negative for our holding. Since the stock closed under the 20 DMA we sold at the opening the next morning and got $1.90 for the 25 CALL options that we had left. We received another $2,750 profit, which came to a total profit of $8,750 for a $4,000 investment or a 219% return in 28 days. This is a very nice return, but has to be averaged with many other trades that may not have been successful.
The PowerOptions site uses Big Charts as the graphing program of choice. Big Charts can be set up to monitor the stock price movement with Bollinger Bands (BB). Once in Big Charts the following procedure will enable you to display the Bollinger Bands with your stock price. In the left hand column of the Big Chart display:
Click "Time Frame" and set Time to 3 months
Set the "Frequency" to daily
Click "Indicators" and set Moving Averages to SMA and 20 (in box)
Set Upper Indicators to Bollinger Bands
Set the Lower Indicator1 to Volume
Set Lower Indicator2 to OBV
Click "Draw Chart" to establish these settings
Scroll to the bottom of the list and click Store Chart Settings
The PowerOptions SmartSearchXL technology can help find BB BO opportunities. SmartSearchXL can scan the entire options market looking for possible breakouts in a matter of seconds. Long calls or long puts can be selected based on the closing price of a stock going beyond the upper or lower bands.
Tools available on PowerOptions, which support a BB trading strategy:
% Stock Volume relative last 90 trading days
Actual break out of a Bollinger Band (top or bottom)
% Range in the Bollinger Band (% BB (20))
Bollinger Band width relative to the moving average (% Band Width (20))
Relative Strength Indicator (RSI)
Stock Price relative to 20, 50, 100, or 250 day moving average
Values can be set for any or all of the above parameters to screen for opportunities. There is also a set of sample screening criteria set up in the Long Call and Long Put strategies.