The most popular volatility breakout indicator is the Bollinger Bands and it can be used to predict monster moves that can make you rich.
If you’ve used the Bollinger Bands for any length of time, you’ll notice that breakout signals are more accurate when the bands are closer together.
Bollinger band width is an indicator derived from Bollinger Bands. In his book, Bollinger on Bollinger Bands, John Bollinger refers to Bollinger band width as one of two indicators that can be derived from Bollinger Bands. The other indicator is %B.
Non-normalized band width measures the distance, or difference, between the upper band and the lower band. Band width decreases as Bollinger Bands narrow and increases as Bollinger Bands widen. Because Bollinger Bands are based on the standard deviation, falling band width reflects decreasing volatility and rising band width reflects increasing volatility.
Bollinger band width is best for identifying volatility and what is known as The Squeeze. This occurs when volatility falls to a very low level, as evidenced by the narrowing bands. The upper and lower bands are based on the standard deviation, which is a measure of volatility. Therefore, volatility contracts as the bands narrow. The bands narrow as price flattens or moves within a relatively narrow range. The theory is that periods of low volatility are followed by periods of high volatility.
The market cycles back and forth between lower volatility (range contraction) and higher volatility (range expansion). In the chart above, lower volatility is highlighted in red while periods of increasing volatility are highlighted in blue. Periods of lower volatility are followed by periods of higher volatility.
Relatively narrow band width (a.k.a. the Squeeze) can foreshadow a significant advance or decline. After a Squeeze, a price surge and subsequent band break signal the start of a new move. A new advance starts with the Squeeze and subsequent break above the upper band. A new decline starts with the Squeeze and subsequent break below the lower band.
As a stock’s price moves sideways, the Bollinger Bands come together as volatility decreases. At this point, you need to look for your entry. When the price breaks the upper Bollinger Band, you have a volatility breakout to the upside and so you go long. If the price breaks below the lower Bollinger Band, you have a volatility breakout to the downside and so you short.
The closer the Bollinger Bands come together, the better the signal is on the breakout above either the upper or lower Bollinger Band wall.
Using Bollinger Bands as a volatility breakout indicator also can be applied to weekly charts or longer timeframes. Volatility and band width on weekly charts is higher than on the daily chart. This makes sense because larger price movements can be expected over longer timeframes.
The danger in using Bollinger Bands as a volatility breakout indicator comes from what is known as a head fake. Head fakes are when the upper or lower Bollinger Band is broke only to reverse a few days later and stop you out of your position.
Some markets are more prone to head fakes than others at different times of the year. Take a look at past Squeezes for the stock you are considering trading and see if they involved head fakes in the past. Another thing that you can do to minimize your losses in the event of a head fake is to trade half a position the first strong day of the Bollinger Band break, adding to the position upon 1 or 2 days confirmation of the breakout and using a parabolic stop to keep from being hurt too much.
For another article on trading volatility check out Volatility Breakout Indicator