Take a look at a one-year daily chart of iShares S&P/TSX Index Fund (XIU, Friday’s close: $17.68). You can pull the chart up from any number of sources including www.yahoo.ca, www.msn.com or www.bigcharts.com. When you pull up a basic chart look for the technical indicators and overlay on the chart the Bollinger bands.

Bollinger bands represent a two standard deviation trading range that is equally distributed around the 20-day moving average. If you like you can add the moving average as another overlay on the chart.

Bollinger bands were created by John Bollinger and typically represent a two standard deviation trading range around the 20-day moving average. The width of the trading range is based on the historical volatility for the underlying stock. When volatility increases the bands widen, when volatility decreases the bands contract.

As stated in Steven Achelis’s, Technical Analysis from A to Z (Chicago: Irwin, 1995), Bollinger has the following to say about this indicator:

• “Sharp price changes tend to occur after the bands tighten, after volatility lessens.”
• “When prices move outside the bands, a continuation of the current trend is implied.”
• “Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.”
• “A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.”

Not only can Bollinger bands be useful in determining which direction a stock is likely to take. Although not the initial intent of Bollinger’s work the bands can also be useful in determining appropriate option strategies depending on your view of the underlying stock.

From my perspective, the bands reflect a trading range for the underlying stock based on its recent volatility patterns which, when you think about it, is how market makers price an option. Placing more weight on the most recent volatility, the options price reflects specific trading ranges around a point in time.

To demonstrate the relationship between Bollinger bands and option premiums I note that the top XIU Bollinger band is at the $17.50 level, while the bottom Bollinger band is around $16.70 per share which suggests a one-month (note: 20 trading days equates to one month) trading range of 70 cents. How does that compare to the trading range implied by say, the XIU October options?

For comparison purposes, the October options (which are a little more than a month to expiration) are implying a 70 cent trading range as can be determined by the XIU October 17.50 straddle (i.e. XIU October 17.50 calls at $0.40 and the October 17.50 puts at $0.30 = total cost for the straddle $0.70).

Applying Bollinger’s work to strategy selection

The next step is to construct a series of rules for building specific option strategies around the trading bands. Which strategies you employ, obviously, depend on your view about the underlying stock.

For example, if the underlying stock is at the lower end of the Bollinger band, bullish traders might consider buying calls. The top end of the range would be the point at which you would consider exiting the position.

If you like XIU which at present is at the top Bollinger band, bullish traders might consider covered call writing or bullish put spreads. The Bollinger bands would be implying a change in trend. But at the top end of the range, a more cautious option strategy would be most applicable. In the middle of the range, bullish traders should also lean towards strategies such as covered call writing or selling cash secured puts.

Bearish traders can use Bollinger bands in much the same way. For example, if the stock were at the top end of its trading range – as defined by the Bollinger bands – bearish traders could buy puts. The lower trading band would be the objective and the point at which you would close out the long put position.

In the middle of a trading range, bearish traders might consider writing bear call spreads. In this case selling the calls with a strike price at the top Bollinger band and buying a call at one or two strikes above that.

Finally, when the stock touching the bottom Bollinger band, bearish traders should only consider bear call spreads.