What are Bollinger Bands?
Bollinger Bands (BB) were created in the early 1980s by financial analyst and trader John Bollinger. Bollinger Bands are widely used as an instrument for technical analysis (TA), which is basically an oscillator meter that indicates whether the market has high or low volatility and also overbought or oversold conditions.
The main idea behind the BB indicator is to highlight how prices are scattered around an average value. More specifically, the indicator is comprised of an upper band, a lower band, and a mean moving average line (also known as a middle band). The two sidebands react to market price action, expanding when volatility is high (moving away from the median line) and contracting when volatility is low (moving toward the median line).
The Bollinger Bands standard formula sets the midline as a 20-day simple moving average (SMA), while the upper and lower bands are calculated based on market volatility relative to the SMA (known as standard deviation). The standard setting for the Bollinger Bands indicator would look like this:
• Intermediate line: 20-day simple moving average (SMA)
• Upper band: 20-day SMA + (20-day standard deviation x2)
• Lower band: 20-day SMA - (20-day standard deviation x2)
BB's standard configuration recognizes a 20-day period and sets the upper and lower bands to two standard deviations (x2) away from the center line. This is done to ensure that at least 85% of the price data will move between these two bands, but the settings can be adjusted according to different trading needs and strategies.
How to use Bollinger bands in trading?
Although Bollinger Bands are widely used in traditional financial markets, they can also be used for cryptocurrency trading setups. Naturally, there are several ways to use and interpret the BB indicator, but the use of Bollinger Bands as an independent instrument should be avoided and should not be considered an indicator of buy / sell opportunities. Instead, BB should be used in conjunction with other technical analysis indicators.
With that in mind, let's imagine how the data provided by the Bollinger Bands indicator could be interpreted.
If the price is above the moving average and exceeds the upper Bollinger band, it is probably safe to assume that the market is too extended (overbought condition). Or, if the price touches the upper band multiple times, it may indicate a significant resistance level.
In contrast, if the price of certain assets drops significantly and breaks or touches the bottom band multiple times, the market is likely oversold or at a solid support level.
Therefore, traders can use BB (along with other TA indicators) to set their buy or sell targets. Or also to obtain an overview of the previous points where the market presented overbought and oversold conditions.
Furthermore, the expansion and contraction of Bollinger Bands can be useful when it comes to predicting times of high or low volatility. Bands can move away from the middle line as the price of the asset becomes more volatile (expansion) or move towards it as the price becomes less volatile (contraction).
Therefore, Bollinger Bands are best suited for short-term trading as a way to analyze market volatility and try to predict upcoming movements. Some traders assume that when the bands expand excessively, the current market trend may be close to a consolidation period or a trend reversal. Alternatively, when the bands get too tight, traders tend to assume that the market is preparing to make an explosive move.
When the market price moves sideways, the BB tends to drop towards the simple moving average line in the middle. Generally (but not always), low volatility and tight deviation levels precede large, explosive moves, which tend to occur as soon as volatility recovers.
Difference with Keltner Channels
Unlike Bollinger Bands, which are based on SMA and standard deviations, the modern version of the Keltner Channel Indicator (KC) uses the True Average Range (ATR) to set the channel width at a 20-day exponential moving average. (EMA). So the Keltner channel formula would look like this:
• Intermediate line: 20-day exponential moving average (EMA)
• Upper channel line: 20-day EMA + (10-day ATR x2)
• Lower band: 20-day EMA - (10-day x2 ATR)
Normally, the Keltner channel indicator tends to be tighter than the Bollinger bands. Consequently, it may be more suitable than BB to detect trend changes and overbought / oversold market conditions in a clearer and more obvious way. Also, the KC indicator generally provides the pre-BB overbought / oversold signal.
On the other hand, Bollinger Bands tend to better represent market volatility as expansion and contraction movements are much broader and more explicit compared to KC. Also, by using standard deviations, the BB indicator is less likely to give false signals, as its width is wider and therefore more difficult to overcome.
Among BB and KC, Bollinger bands are the most popular. However, both indicators are good, especially for short-term trading setups, and can also be used together to provide more reliable signals.
Some final considerations as a summary:
• Bollinger Bands provide a relative definition of high and low. By definition, the price is high in the upper band and low in the lower band.
• If more than one indicator is used, the indicators should not be directly related to each other. For example, a momentum indicator could complement a volume indicator successfully, but two momentum indicators are no better than one.
• Band labels are just that, labels are not signs. A top Bollinger Band tag is NOT itself a sell signal. A lower Bollinger Band tag is NOT itself a buy signal.
• In trending markets, the price may, and if it does, raise the Upper Bollinger Band and lower the Lower Bollinger Band.
• Closings outside Bollinger Bands are initially continuation signals, not reversal signals.
• The default 20-period parameters for moving average and standard deviation calculations, and two standard deviations for band width are just that, default values. The actual parameters required for any market may be different.
• For a consistent price analysis: if the average is lengthened, the number of standard deviations must be increased; from 2 to 20 periods, to 2.1 in 50 periods. Similarly, if the average is shortened, the number of standard deviations should be reduced; from 2 to 20 periods, to 1.9 in 10 periods.
• Traditional Bollinger Bands are based on a simple moving average. This is because a simple average is used in the calculation of the standard deviation and we want to be logically consistent.
• Bollinger Bands can be used on bars of any length, 5 minutes, one hour, daily, weekly, etc. The key is that the bars must contain enough activity to give a solid picture of the pricing mechanism at work.
• Bollinger Bands do not provide ongoing advice; rather they help to identify configurations where the odds may be in your favor.