What are Bollinger Bands?
Bollinger Bands were developed by financial analyst and stockbroker John Bollinger in the early 1980s. Bollinger Bands are a frequently used tool for technical analysis (TA). It is basically an oscillator measurement that shows whether the price fluctuates high or low in the market and whether there are overbought or oversold conditions.
The main idea underlying the BB indicator is to highlight how prices are distributed around the average value. For this, the indicator has an upper band, a lower band, and a middle moving average line (also known as the middle band). The sidebands react to market price movements, widening when price volatility is high (moving away from the middle line) and narrowing when price volatility is low (approaching the middle line).
The standard Bollinger Bands formula determines the middle line as the 20-day simple moving average (SMA), while the lower and upper bands are calculated by comparing the market volatility to the SMA (called the standard deviation). The standard formulas for the Bollinger Bands indicator are as follows:
- Middle 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)
Standard BB formulas use 20-day periods and place the upper and lower bands two standard deviations (x2) from the midline. The purpose of doing this is to ensure that at least 85% of the price data will move between the two bands, but the formulas can be rearranged to suit different needs or trading strategies.
How to use Bollinger Bands when trading?
While Bollinger Bands are often used in traditional financial markets, they can also be used in cryptocurrency trading environments. Naturally, there are various ways to interpret and use BB indicators, but people should avoid using Bollinger Bands alone as a sole tool and not as an indicator of buying/sell opportunities. Instead, BB should be used in conjunction with other technical analysis indicators.
With this in mind, let’s consider how one would potentially interpret the data provided by Bollinger Band indicators.
If the price rises above the moving average and crosses the upper Bollinger Band, it is probably safe to assume that the market is overbroadened (overbought). Or, if prices touch the upper band more than once, it could represent a meaningful level of resistance.
Conversely, if the price of a certain asset drops significantly and touches or moves below the lower band more than once, the market is likely to be oversold or have found a strong support point.
Hence, traders can use BB (along with other TA indicators) to set trading targets or to review where the market has previously shown overbought and oversold conditions.
In addition, expansions and contractions in Bollinger Bands can be useful when trying to predict high and low volatility times. As the price of the asset becomes more volatile (widening), the bands move away from the midline, or as the price becomes less volatile (contraction), the bands move closer to the midline.
Hence, Bollinger Bands are better suited for short-term trading for analyzing market fluctuations and predicting future movements. Some traders assume that when the bands become excessively wide, the market trend is approaching a consolidation period or a change in direction. Rather, it is assumed that the market is preparing to make an explosive move when the bands get too tight.
When market prices are sideways, BB tends to narrow towards the middle simple average line. Often (but not always) low volatility and tight deviation levels precede large and explosive moves that tend to occur the moment volatility rises.
Bollinger Bands and Keltner Channels
Unlike Bollinger Bands, which are based on the SMA and standard deviation, the modern version of the Keltner Channels (KC) indicator uses the Average True Price Range (ATR) to determine the channel width around the 20-day Exponential Moving Average (EMA). So the Keltner Channel formula looks like this:
- Middle line: 20-day exponential moving average (EMA)
- Upper channel line: 20-day EMA + (10-day ATRx2)
- Lower channel line: 20-day EMA – (10-day ATRx2)
Typically the Keltner Channel indicator tends to be tighter than Bollinger Bands. As a result, it may be more appropriate than BB to more clearly and distinctly notice trend direction changes and overbought/sold market situations. In addition, the KC indicator gives the overbought/sold signal earlier than the BB.
On the other hand, Bollinger Bands better represent market fluctuations because expansion and contraction movements are much wider and more pronounced compared to KC. Moreover, since the BB indicator uses the standard deviation, it is less likely to give false alarms because the bandwidth is larger and therefore more difficult to circumvent.
Between BB and KC, Bollinger Bands are the more popular. However, both indicators are successful (especially for short-term trades) and can be used together for more reliable signals.
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