There is one surefire way to find volatility in the market as a technician of trading.
If you have been with me for any length of time, you know that I am a technical trader.
And, if you have been in the markets for any length of time you’ve probably heard somebody say ‘volatility is a trader’s best friend.’
The Bollinger bands are an amazing tool to use to find volatility. Every time I wander away from using the tool, it smacks me in the back of the head and tells me to pay attention as it works almost all of the time.
You are going to be hearing more about this over the next few months as it is a foundation of being a trader. If you can’t find reliable volatility you are not a trader, you are an investor just searching for capital appreciation.
There is nothing wrong with buying a gold coin and tossing it in a safe – but you are here, That tells me that you want something more, you want actionable movement so you can see measurable growth in your account.
We have three goals for today:
- Teach you how the Bollinger bands are calculated – so you understand how they work.
- Explain what the Bollinger bands are going to tell you about market volatility.
- Show how you can use the Bollinger bands as a trade catalyst.
This is Technical Analysis 101 – we are students of the market and the Bollinger bands are your guide.
Imagine this, you just place a trade that is 4 weeks to expiration, and the company started to make a move that caught your eye…
Out of nowhere, the company decides that it is just going to move sideways and the only thing you can think about is the theta (Time decay – when a position loses value as you approach expiration).
All your premium is just starting to melt away because the stock is not moving, there is no volatility in sight.
All this trouble because for a brief moment you stopped looking at the Bollinger bands.
Maybe, you don’t even know what they are, but that is okay, you’re in the right place.
What are the Bollinger bands?
A Bollinger band is a technical analysis tool defined by a set of trendlines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of a security’s price, but which can be adjusted to user preferences.
How are the Bollinger bands created?
It is likely your broker just has a button to create the Bollinger bands on any chart you pull so you don’t need to know the math behind this indicator – but understanding how they are plotted is integral to knowing why they work.
This Forward looking indicator looks back at how volatile a stock has been in the past to estimate the range the stock will naturally operate in moving forward.
In the case of my charts, it looks at the last 20 days worth of closes and takes a two standard deviation – or 95% of the data points just excluding major outliers – and plots a line using this information.
The real magic of all of this is that it’s based on math – natural laws of the universe, it removes the guesswork and emotion from your trading.
Using Bollinger bands to trade volatility.
The wonderful thing about technical analysis is there is both an art and a science to it.
In the case of the Bollinger bands, the primary thing I want you to watch for is the distance between the upper and lower bands.
Watching the separation between the bands will start to show you how traders operate.
If the bands are spread apart – it is likely the volatility is passed and it is not the time to be placing a trade.
There is a secret hidden in the Bollinger bands that a lot of people will miss – the contractions.
When we see the Bollinger bands tighten, it tells you that there is something unusual happening in the stock or ETF only to be followed by a natural movement in the way of a volatility spike.
Don’t take my word for it – take a look at Huntington Bancshares Inc. (HABN):
The stock had been just jumping up and down in price but there was no breakout action happening – the stock was essentially just moving from the left to the right with no meaningful deviation from its average price.
Simple, this will tell you that a moment of visceral volatility is coming… now you just need a direction to play it. That is when you start adding in the 20-day and 50-day moving averages to find the direction of the trend.
The math leads you to the breakout – and causes the volatility that a trader will be foaming at the mouth to take advantage of. This can easily carry you to a sizable profit if you know what to watch for.
November 26 2022