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Bollinger Bands is one of the most widely used volatility indicators. The band is developed by John Bollinger and as the name suggests these are bands (ranges) above and below the price movements. The bands widen when the volatility increases and narrow when volatility decreases. They can be used to identify M tops and W bottoms or to determine the strength of the underlying trend.

The band uses 20 day SMA’s for the calculation of the middle band and for the upper and lower band, SMA plus or minus 2 standard deviations of the past 20 days prices. A simple moving average is used because the standard deviation formula also uses a simple moving average. 95% of the price data should fall between the two bands. The prices are considered to be overextended on the upside (overbought) when they touch the upper band. They are considered to be overextended on the downside (oversold) when they touch the lower band.

“W” Bottoms

Arthur Merrill developed 16 patterns with a basic W shape. A W bottom forms in a downward and involves two reaction lows. In particular you should look for W bottoms where the second low is lower than the first, but holds above the lower band. There are a four steps to confirm a W bottom with Bollinger bands.

1. A reaction low is formed (usually below the lower band, but not necessary)
2. Bounce towards the middle band
3. There is a new price low in the security, this low holds above the lower band (shows less weakness on the last decline)
4. The pattern is confirmed with strong move off the second low and a resistance break.

“M” Tops

According to Bollinger, tops are usually more complicated and drawn out than bottoms. M top is very similar to a double top, though the highs might not always be equal. The second high can be lower or higher than the first high, but Bollinger suggests looking for a sign of non-confirmation when a security is making new highs. A non confirmation occurs with three steps:

1. A reaction high is forged above the upper band
2. Pullback towards the middle band
3. Prices move above the previous high but fail to reach the upper band

The inability of 2^nd set of price to reach the upper band shows waning movement, which can foreshadow a trend reversal. Final confirmation comes with a support break or bearish indicator signal.

Walking the bands

Moves above or below are not signals per se, but rather act as tags. A move to the upper band shows strength while a move towards the lower band shows weakness. According to the momentum oscillators overbought and oversold signals do not necessarily provide a bullish or bearish signal. Hence the prices can actually walk the band with numerous touches during a strong uptrend and not face the trend reversals.

During this period, prices won’t close above upper band if in a downtrend or won’t close below the lower band if in an uptrend. Such a pattern of the prices staying within the bands (in sync with the underlying trend is called walking the trend.

Let us now look at an example of the above 3 signals and understand how it looks like when it is happening.

In the above chart you can see how we have the W bottoms and the M tops at work. With the top you can see the pullback move (the 3^rd spike) and how it was unable to cross the last high and also the upper band.

In the above chart you can see how in the walking the bands for the underlying uptrend the prices are not able to close past the lower band, and hence they keep under the band all this time.

In your trades, Bollinger bands can be of great help in understanding the price moves. According to Bollinger, the prices for 89 – 90% of the time should be within the bands, the rest can act as your cue for next move.

Utilize them to see how volatile the last 20 days have been to make an informed judgment about your scrip.

Bollinger Bands can be used to decide on option trades as well. Narrowing Bollingers indicate that volatility is falling. If the bands have narrowed significantly over their 2-3 month average, it could be time to buy volatility on that stock. Compression of Bollinger Bands is usually signal of a coming volatility surge.

We discussed historical and implied volatility previously. The question now is how to profit from it. As you can see from the chart on the left, the market implied volatility (VIX) keeps oscillating (greed-fear-greed-fear…) A simple strategy could be to sell when VIX is at its lows (greed is predominant) and buy when VIX peaks (fear is predominant). Notice the (loose) correlation between Nifty peaks/troughs with the VIX troughs/peaks.

Buy why trade the underlying (in this case, the Nifty), when you can trade volatility directly? Using stock & index option strategies, you can profit from volatility while being indifferent to the actual underlying scrip. For example, you can buy Straddles (Nifty August 5200 Long Straddle) that appreciate in value if volatility increases, irrespective of whether the underlying stock increases or decreases in value. Ditto with Strangles (Nifty August 5200/5300 Strangles).

Volatility strategies are often used when the fundamentals of the underlying scrip is in doubt. For example, there was a fair amount of uncertainty around INFY results: global IT spending slowdown plus company specific problems. However, it has a track record of execution and is considered to have good corporate governance (ie, a good company to own long term.) So instead of taking a directional bet on the stock, traders put on straddles betting on volatility instead.

To conclude our discussion:

• Choose low-volatility stocks for your long-term portfolio
• Know the difference between historical volatility and implied volatility
• Know what you are trading (fundamentals vs. technicals)
• Be aware of the different trading instruments available to you and know when to use them

Previously, we discussed historical volatility – a measure of volatility already exhibited by the stock. However, history, in and of itself, doesn’t tell you much. There’s another measure, called “Implied Volatility” (IV, for short) that embodies the market’s expectation of future volatility. IV is a useful gauge of the uncertainty “priced-in” by market participants. The chart on the left gives you a comparison between the near maturity IV of ATM calls vs. historical volatility exhibited by INFY.

So what exactly is IV? One of the inputs for the Black–Scholes-Merton model for option pricing is volatility. When you use historical volatility for this input, the price calculated by the model doesn’t match the price at which the market is trading that option. So IV is that value of volatility that brings the output of the BSM in-line with the market price.

How exactly is IV useful? IV allows you to determine a stock’s one-standard deviation move (a stock tends to stay within its one standard deviation move 68% of the time.) If the market is “right”, IV should lead observed (or spot) volatility. So if you plan to hold a stock for less than three months, you should be watching the ATM IVs of the on the run option as well.

Implied Volatilities are specific to stocks who’s options are traded. It is very hard to generalize the IV of one scrip to a sector or the market. That’s where VIX comes in. India VIX is a volatility index based on the NIFTY Index options. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the NIFTY to move up or down 15%/√12 = 4.33% over the next 30-day period.

Implied Volatility and its market aggregate, the VIX, are key gauges that any investor should track on a regular basis. A big variation usually signals “something” is afoot and allows the investor to position himself appropriately. When possible, you should always combine historical volatility and implied volatility to get a true sense of where the underlying stock or index is headed.