Ian Cooper WealthDaily.com
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In the spirit of our ongoing options education program, we like to answer as many reader questions as we can.

This one comes from Michael R: “Ian, I've never made so much money than I have with you guys. With other services I'm trading they also use Bollinger Bands, but I don't understand them. Can you help?”

Absolutely.

Bollinger Bands are a popular technical indicator for traders in determining overbought and oversold conditions. In a range-bound market, for example, it works even better as prices travel between two “rubber bands”, or like balls bouncing off the walls.

But using the Bollinger Band as a sole buy/sell indicator isn't smart. It's why we also use W%R and candlestick signals to help call tops and bottoms. As John Bollinger says, “tags of the bands are just that - tags, not signals. A tag of the upper Bollinger Band is not in and of itself a sell signal. A tag of the lower Bollinger Band is not in and of itself a buy signal".

And if you try to use Bollinger Bands by themselves, you can get stopped out or worse as prices “walk the bands” without direction. Again, it's why we use W%R and candlesticks, too.

As we said in “How to Trade Like a Hedge Fund: Secrets of an Options Trader”:

With Bollinger Bands (plotted at standard deviation levels above and below moving averages), stock prices tend to stay within the upper and lower bands. So, when the prices move above the upper Bollinger Band, are coupled with a bearish candlestick read (gravestone doji, for example), and an extreme overbought W%R read is present, we expect a reversal at the top.

Bollinger Bands allow users to compare volatility and relative price levels over a period of time. They consist of three bands:

• A simple moving average (SMA) in the middle...
• An upper band (SMA plus 2 standard deviations)...
• A lower band (SMA minus 2 standard deviations)...

Standard deviation, a statistical term that provides a good indication of volatility, ensures that the bands will react to price movements and reflect periods of high and low volatility. Sharp price increases (or decreases) will lead to a widening of the bands.

In late November 2006, shares of AIG were grossly overbought, for example. Technically, once we got word of extremely overbought W%R read (as seen in mid-November), we knew AIG was overdue for a correction. Also notice at the time, the underlying stock crossed above the upper Bollinger Band with a doji cross indicating near-term reversal, which we got.

Or every time Forest Laboratories (FRX) touched the upper Bollinger Band, it would sell off.

Let's make this a bit simpler. When we use the Bollinger Bands, the closer the market prices move to the upper Bollinger Band, the more the stock market is considered overbought. The closer the prices move to the lower Bollinger Band, the more the stock market is considered oversold. We're not going to get into the scientific structures and Bollinger band calculations with each trade. We'll be here until New Year's 2012 doing that.

Again, using Bollinger Bands by themselves isn't a smart trading idea. It's why we also use W%R and candlesticks. But the bands have become crucial in technical markets. By using the band functionality, and examining them as “rubber bands” that, when pulled too tight can snap back to the mean, traders can achieve unimaginable profits... just as we have in Options Trading Pit.

Here's another question from Marty C. “Ian, do you recommend using stop losses and trailing stop losses?”

Yes. In Options Trading Pit, we like to use a “mental stop loss rule” of at least -35%. With trailing stop losses, we like to use at least -25% when we're showing a nice gain.

For instance, if you bought your option at $20, you might want to plug in a stop-loss order to sell if the price drops by 35% ($13).

On the other hand, if your option rises, you could set a trailing-stop. This is the opposite of a stop-loss and locks in gains for you at a set level. For example, if you buy an option for $20 and it rises to $40, you could set a trailing-stop at $30 to lock in a 50% gain.

Note: Make sure your broker understands that you want a stop-loss order and not a sell order – otherwise he might execute the order immediately, and you could end up reselling an option worth $10 for $7.50. Simple mistakes like this illustrate why it is essential to find a broker you trust… or learn to trade yourself.

Bottom line: Give your broker instructions about your options. Don’t get left holding a worthless contract, or shares you never intended to purchase.

That's all for this week. Stay tuned for more shortly. And, as always, if you have a question, feel free to e-mail it to us for features in this daily e-letter.

For more on options trading, we direct your attention to the following:

• How to Invest in Options
• How to Buy LEAP Options
• Options Intrinsic Value
• ETF Options Trading
• Crisis Investing
• Lockup Expirations
• How to Trade Like a Hedge Fund: Secrets of an Options Trader
• Options Trading Volume

Stay tuned for more options education next week, when we'll dive into naked options trading.
Editor's Note: Members of Ian's Options Trading Pit advisory are getting the options trading lessons of their lives... and finding themselves all the richer in the process. In fact, so far they've enjoyed 61wins in 75 trades, cumulative gains of 4.462%... and an average hold time of 11 days. Isn't it time you made gains like this?

For eight years, he's avoided the herd mentality of Wall Street.

That would explain why he bought housing before the 2004 rise and shorted sub-prime and big housing names before the 2007 fall . . . all while the "experts" suggested doing the opposite.

In 1999, Ian left a job in public relations because he couldn't stand saying good things about companies he didn't like, and he's been a financial analyst ever since. His passion for Wall Street, technical analysis and the idea of fast money fueled the move.

Since then, Ian has written numerous articles on topics as diverse as trading news, mergers and acquisitions, crude oil, housing, and emerging market opportunities.

He's appeared in Investor's Business Daily and Forbes.com and has been a frequent guest on Money Matters with Barry Armstrong, Stock Dr. with Lee Seiler, and On the Money with Mike Stein.

Nowadays, Ian relies on technical and fundamental analysis for investment decisions, and has leveraged his options and stock trading passion to fuel his search for quick profits, which is just what you can expect him to deliver to his readership.