Bollinger Bands are a technical indicator created by renowned technical trader John Bollinger in the early 1980's. There are numerous publications, as well as John's website www.bollingerbands.com, that go into great detail on this popular tool used by many traders. This article will touch on the basic parameters of Bollinger Bands and how they may be used in options trading.

Bollinger Bands are considered to be a volatility indicator, similar to the Keltner channel indicator. Their purpose is to provide traders a relative definition of highs and lows. This means that prices are high at the upper band, and low at the lower band. Bollinger Bands can help recognize price patterns, and can be useful to traders of all levels in their trade entry, management and exit strategies.

Below is a screenshot of a chart of the SPX with Bollinger Bands set at their default settings:

SPX 6 Month Chart from Think or Swim with Bollinger Bands

The Bollinger Bands study as shown on Thinkorswim consists of two lines plotted, two standard deviations above and below a moving average. The standard deviations can be changed based on a trader's choice, as can the other settings will are explained below. The standard deviation lines change as price and volatility goes up or down.

The upper band can indicate an overbought level, while the lower band can indicate an oversold level. However, as we have all seen at times, if prices approaches either band, or bounces off, it is not a guarantee of a breakout or reversal.

The default settings in the above Think or Swim chart are shown below:

**Close**This represents the price which is used to calculate the moving average and the standard deviation. Depending on which charting software is being used, traders can choose other parameters such as open, volume, etc.**0**This is the “displace” setting; the number of bars to shift the study forward or backward. TOS' default setting of zero is preferred by many traders.**20**This is the “length” setting; the number of bars used to calculate the moving average and standard deviation. In this case 20 is the 20-day simple moving average.**-2.0, 2.0**These two settings are the number of standard deviations up and down to plot the lower bars**Simple**This is the moving average; this can also be changed to Exponential, etc., based on a trader's preference. On the chart, the moving average is the middle line, and the upper/lower lines represent the standard deviations up and down as selected.

The way traders interpret and use Bollinger Bands varies, depending on the individual and trading style. Some choose to buy when price touches the lower Bollinger Band, and close the position when the price rebounds to touch the moving average (center line). Others may choose to go long when price breaks out above the upper Bollinger Band, or go short if the price falls below the lower band. It is also worth noting that the use of Bollinger Bands is not limited to stock traders. Because the Bollinger Bands indicator is a volatility study, some options traders sell options when the bands are spread apart, or buy options when the bands are close together. In both of these cases, the trader is expecting volatility to retrace to the average historical volatility level for that particular underlying.

When the Bollinger Bands are close together, it usually indicates a period of low volatility. On the other side of the coin, as the bands expand and move farther apart, an increase in volatility is indicated. Lastly, when the bands only have a slight slope and track fairly even for a period of time, it indicates that the price of the underlying may continue to channel in between the bands.

Many traders also like to use Bollinger Bands in conjunction with other indicators to confirm price action, such as a trendline. If the trendline confirms the movement suggested by the Bollinger Bands, the trader may have more confidence that the bands are predicting a correction in the price action in relation to market volatility.

I hope this “Bollinger Bands in a Nutshell” has given some of you an insight on this popular technical indicator. Like all the technical indicators, they are not “guaranteeing” price action, but can be used as a guide for traders in their entry, management, and trade exits. Subsequent articles will cover more technical indicators widely used by traders of all levels.

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]]>The standard deviation of a particular stock or index will inform you about the possible movement over a period of time, based on probabilities.

- The higher the volatility, the bigger the standard deviation.
- The further out in time the date is, the bigger the standard deviation.
- The larger the stock or index price is, the bigger the standard deviation.

These standard deviations are important to options traders because they give definitive metrics which can be used to gauge the probability of a successful trade. Of course, there is no indication of the direction of a potential move; you as a trader can use your own technical expertise and chart analysis in conjunction with the standard deviation metrics. It is also worth mentioning that no trade can have a 100% probability of success. Even trades with boundaries of profitability of three standard deviations have the small but real probability of moving outside the predicted range of movement.

“When you really believe that trading is a probability game, concepts like right or wrong, or win or lose, no longer have the same significance.” Mark Douglas

The mathematical definition of “standard deviation” is a measure of the dispersion of a set of data from its mean. The more the data is spread apart, the higher the deviation.

Represented by a bell curve, the graph below illustrates standard deviation.

Breaking this down a bit further, if the data points are all near the mean (center of the graph), then the standard deviation is close to zero. The farther away the data points are from the mean, the higher the standard deviation. The bell curve is a normal distribution, and demonstrates that among a certain number of samples, there is normal outcome. In options trading, these normal outcomes can be used as a tool.

- +1/-1 standard deviation covers 68.2% of occurrences
- +2/-2 standard deviation covers 95.4% of occurrences
- +3/-3 standard deviation covers 99.6% of occurrences

Capital Discussion's site includes an excellent standard deviation calculator at:

https://members.capitaldiscussions.com/go/c.standard-deviation-calculator

Using RUT as an example for the December expiration (43 days away), with the price of RUT at 1190 (closing price 11/4/15), and the ATM put option IV at 18.4%, you can see how the calculator breaks down the projected price movements into increments to help determine how the various moves may affect your position.

A one standard deviation on the above example is 75.13 points. What that means is any time between now and December 18 (expiration), it is possible that RUT price may be between 1114.87 and 1265.13, based on the probability calculation.

The standard deviation allows me to see where the likelihood of price movement will be during the life of the trade. Based on this calculation, there is a 68.2% probability that RUT will stay within the 1114.87 to 1265.13 price range. This, of course, relates to the data as entered today. Any time new data is entered, the standard deviation calculations are very likely to change.

- If price moves a standard deviation or more in one day, or multiple days in a row, it is a sign of increased volatility in the market. This may be a time to consider reducing position size, make earlier adjustments, or adding hedges to protect the position. For example, if there is a 1.5 standard deviation move in one day, it may be in your trade plan to purchase a long call, put, or spread to protect the position.
- Standard deviation can be helpful to determine which type of trade to enter. In times when standard deviations are higher because of increased volatility, some sort of directional play may be appropriate versus a non-directional strategy such as an Iron Condor.
- Standard deviation can be used as a guideline for trade entry. For example, one of the trades in my plan consists of a Weekly Iron Condor. If the underlying has moved more than a standard deviation on the planned entry day, I do not enter this short term position.

Standard deviation is just one more tool available to options traders. It goes without saying that volatility, days to expiration, position p & l, etc. are other factors to base your trade entry, exits, and adjustments as per your own trade plan.

How do you use standard deviation in your options trades? Feel free to comment below.

]]>One measure of risk that is common for option traders is to use standard deviations of movement. I built a popular Standard deviation calculator to calculate the range of movement for a given set of numbers. It was accessed nearly 500 times in the past week!

An option trader can also use Delta to estimate the probability that an option will expire in the money. If you sell an iron condor, you would add up the absolute values of the deltas to give you the rough approximation of the probability of the entire trade expiring in the money.

Many of the Capital Discussions members trade the RUT as the underlying. Let's put a hypothetical trade on:

Symbol | Expiry | Action | Quantity | Strike | Type | Price | Delta |
---|---|---|---|---|---|---|---|

RUT | JUL5 | BUY | +10 | 1310 | CALLS | 2.28 | +9.46 |

RUT | JUL5 | SELL | -10 | 1290 | CALLS | 6.20 | +21.4 |

RUT | JUL5 | SELL | -10 | 1200 | PUTS | 11.15 | -20.5 |

RUT | JUL5 | BUY | +10 | 1180 | PUTS | 7.85 | -14.5 |

Here is a summary of the position:

Delta | Gamma | Theta | Vega | DTE | SV | ATM Call IV |
---|---|---|---|---|---|---|

-59.16 | -3.72 | 193.3 | -576.3 | 25 | 11.7% | 18.7% |

This is what it looks like in OptionVue software:

If you look at the full size image, you'll see on the left that OptionVue is estimating an 83% probability of profit at expiration. Pretty good right?

Statistical Volatility (SV) is backwards looking and shows you what the underlying actually did. Implied Volatility (IV) is normally what traders use to look forward to estimate their probabilities. A common IV is the Call at-the-money IV for the expiration you are trading in. In this case, that's a volatility of 18.7%, which is 7.0% higher than SV in our example. The market is anticipating higher volatility.

Notice the two standard deviation range expanded quite a bit. The price went from 1174.22 to 1131.95, or a 42.27 point further drop! Our probability of profit went from 83% to 61%. Ouch. Not quite as safe as we thought it was.

Volatility will increase. Let's look at the volatility chart to see how much it might go up:

It is reasonable to assume volatility could rise an addition 3% if the market sells off. Let's bump the volatility up to 21.7% and see how things look:

Things got even worse! Our probability of profit isn't 83% but is now at 54%. Our two standard deviation move lower boundary is at 1114.32, or 59.90 points lower that we initially thought it was.

When you are evaluating a trade during lower volatility, you can often find very comforting percentages, but if volatility rises, the numbers get worse very quickly. Be prepared for fast moving markets and plan on volatility rising. Don't assume the probability of profit will remain the same or improve as time passes. If you get a quick market move and volatility spikes, your beautiful risk chart can transform into an ugly chart very quickly.

Don't get lulled into a false sense of security. Plan on volatility rising and the standard deviation ranges expanding as volatility rises.

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