What are Bollinger Bands?
John Bollinger, a financial analyst and trader, created Bollinger Bands (BB). They are widely used for Technical Analysis (TA). Bollinger Bands are an oscillator meter. It shows whether the market is volatile and whether it is overbought/oversold.
The BB indicator shows how prices are spread around the average. It consists of three bands: the upper, lower, and middle bands of the moving average. These two bands respond to market price movements by widening when volatility is high (moving away or toward the middleline), and narrowing when volatility is low (moving towards the middleline).
Bollinger Bands’ standard formula sets the midline at a 20-day simple Moving Average (SMA). The upper and lower bands are determined based on market volatility relative the SMA (which we call the standard deviation). These are the default settings for the Bollinger Bands indicator:
- The middle line: A simple moving average of 20 days (SMA).
- Upper band: 20-day SMA+ (20-day standard deviation x2)
- Bottom band: 20-day SMA – (20-day standard deviation x2)
This confirms the 20-day period. It also sets the upper and low bands to two standard deviations from the middleline (x2). This is to ensure that at most 85% of price data moves within these two bands. However, the settings can be modified to meet different trading strategies and needs.
How to use Bollinger Bands for trading?
Bollinger Bands are a widely-used tool in traditional financial markets. However, they can be customized for cryptocurrency trading. There are many ways to interpret and use the BB indicator. However, it shouldn’t be used as a standalone tool. It should not be used as an indicator for buy/sell opportunities. The BB indicator should be used with other technical analysis indicators.
Let’s now consider how we might interpret the Bollinger Bands indicator data.
If the price exceeds the Bollinger Band and breaks above the moving average, it’s likely that the market has become excessively inflated (a state known as overbought). If the price touches the upper Bollinger Band multiple times, it could indicate significant resistance.
Contrarily, if a particular asset’s price drops dramatically and is much higher than the lower range or touches it, then there is a possibility that the market is oversold or will find strong support.
Traders can also use BB, along with other TA indicators, to determine their buy or sell goals. You can also see previous points that indicated overbought or oversold market conditions.
The Bollinger Bands’ width and height can also be used to predict high or low volatility moments. The midline can be moved away or towards the middle when an asset’s price is more volatile (expansion).
Bollinger Bands can be used to forecast future movements and analyze market volatility. Some traders believe that if the bands become too wide, it could indicate that the market is nearing a consolidation phase or trend reversal. However, traders may assume that the market is ready for an explosive move if the bands are too narrow.
The BB tends towards the midline of that moving average. Low levels of volatility, abrupt deviations and volatility are often preceded by large and explosive movements. These tend to occur when volatility is recovering.
The Bollinger band compression trading strategy is notable. It involves finding low volatility areas, which are highlighted with the abbreviation “BB”. This compression strategy is neutral, and doesn’t give any indication of market direction. Therefore, traders often combine compression strategies with other TA methods like support and resistance lines.
Bollinger Bands vs. Keltner Channels
The Bollinger Bands are based upon standard deviations and SMA. However, the Keltner Channels (KC), indicator currently uses the Average True Range (ATR), to adjust the channel width for the 20-day EMA. The Keltner channel formula will look something like this:
- Medium Line: 20-Day Exponentially Moving Average (EMA).
- Upper band: 20-day EMA+ (10 day ATR x2)
- Bottom Band: 20-Day EMA x (10-Day ATR x2)
Keltner channels are usually narrower than Bollinger bands. In some cases, however, the KC indicator may be more suitable than the BB indicator to determine trend reversals or overbought/oversold situations (more obvious signs). KC also gives overbought/oversold signals much earlier than BB.
Bollinger Bands, on the other hand, tend to better reflect market volatility, since the expansion and contraction movements of Bollinger Bands are wider and more pronounced than KC. BB indicators are less likely to show false signals when used with standard deviations because their width is greater and thus more difficult to exceed.
The BB indicator is the most widely used. Both tools are useful, but they can also be used in combination for short-term trading setups. These two parameters can be combined to give more reliable signals.