There are two basic ways to trade volatility:
- Buy options with low volatility in hopes that volatility will increase and then sell back those options at a higher price.
- Sell options with high volatility in hopes that volatility will decrease and then buy back those same options at a cheaper price.
Since Bollinger Bands adapt to volatility, Bollinger Bands give options traders a good idea of when options are relatively expensive (high volatility) or when options are relatively cheap (low volatility). The chart below of Wal-Mart stock illustrates how Bollinger Bands can be used to trade volatility:
Buy Options when Volatility is Low
When options are relatively cheap, such as in the center of the chart above of Wal-Mart when the Bollinger Bands significantly contracted, buying options, such as a straddle or strangle, might be a good options strategy.
The reasoning is that after sharp moves, prices tend to stay in a trading range to rest. After prices have rested, such as periods when the Bollinger Bands are extremely close together, then prices usually will begin to move once again. Therefore, buying options when Bollinger Bands are tight together, might be a smart options strategy.
Sell Options when Volatility is High
At times when options are relatively expensive, such as in the far right and far left of the chart above of Wal-Mart when the Bollinger Bands were significantly expanded, selling options in the form of a straddle, strangle, or iron condor, might be a good options strategy to use.
The logic is that after prices have risen or fallen significantly, such as periods when the Bollinger Bands are extremely far apart, then prices usually will begin to consolidate and become less volatile. Hence, selling options when Bollinger Bands are far apart, potentially could be a smart options volatility strategy.
