How to Use Bollinger Bands?

Basics

John Bollinger, a financial analyst, and trader, developed the Bollinger Bands (BB) in the 1980s. These bands are a commonly used technical analysis tool and function as a measure of market volatility and overbought or oversold conditions.

The BB indicator's central concept is to illustrate price distribution around an average value. It consists of a middle moving average line, also called the middle band, and two sidelong bands. The sidelong bands respond to market price movements by expanding when volatility is high and contracting when volatility is low, indicating whether the market has high or low volatility and overbought or oversold conditions.

How Does Bollinger Bands Work?

When applying the Bollinger Bands formula, the middle line is established as a 20-day simple moving average (SMA). The upper and lower bands are calculated based on the market volatility relative to the SMA (known as the standard deviation). The standard Bollinger Bands settings are as follows:

Middle line: 20-day SMA

Upper band: 20-day SMA + (20-day standard deviation x2)

Lower band: 20-day SMA - (20-day standard deviation x2)

The formula considers a 20-day period and fixes the upper and lower bands to two standard deviations (x2) away from the middle line. This guarantees that at least 85% of the price data will remain within these two bands. However, traders may alter the settings to match their requirements and trading techniques.

How to Use Bollinger Bands?

The Bollinger Bands are widely used in traditional financial markets, but they can also be utilized in cryptocurrency trading setups. However, the BB indicator should not be used as a standalone instrument and should not be regarded as an indicator of buying/selling opportunities. Instead, it is recommended to use BB in conjunction with other technical analysis indicators.

With this in mind, let's explore how one might interpret the information provided by the Bollinger Bands indicator. If the price surpasses the moving average and exceeds the upper Bollinger band, it may imply that the market is overextended (overbought condition). Alternatively, if the price repeatedly touches the upper band, it may indicate a significant resistance level. On the contrary, if the price of a given asset experiences a sharp decline and reaches or surpasses the lower band multiple times, it may imply that the market is either oversold or has discovered a significant support level.

Application for Trading Strategies

Consequently, traders can utilize BB, along with other TA indicators, to establish their buying or selling objectives. They may also utilize it to gain a broad understanding of the previous market conditions where overbought and oversold conditions were present. Moreover, the Bollinger Bands' expansion and contraction can provide useful information when anticipating moments of high or low volatility. As the asset price becomes more volatile, the bands can move away from the middle line (expansion), while they move closer to it as the price becomes less volatile (contraction or squeeze).

Short-Term Trading

Therefore, the Bollinger Bands are more fitting for short-term trading, as they allow traders to examine market volatility and predict future movements. Some traders believe that when the bands are excessively expanded, the current market trend may be nearing a consolidation period or a trend reversal. Conversely, when the bands are too tight, traders tend to believe that the market is preparing for a major movement.

Bollinger Bands Squeeze

The Bollinger Bands can narrow towards the middle line when the market price is moving sideways. This can often indicate low volatility and tight deviation levels that precede large and explosive movements once volatility picks back up. Traders have developed a strategy known as the Bollinger Bands Squeeze to identify these low-volatility zones characterized by BB contraction. However, this strategy is neutral and doesn't give a clear direction for the market, so traders often use it with other technical analysis methods like support and resistance lines.

Bollinger Bands vs. Keltner Channels

The Keltner Channels (KC) indicator is a modern tool for technical analysis. Unlike Bollinger Bands, KC uses the Average True Range (ATR) to determine the channel width around a 20-day Exponential Moving Average (EMA). Thus, the formula for Keltner Channels would be as follows:

• Middle line: 20-day EMA
• Upper band: 20-day EMA + (10-day ATR x2)
• Lower band: 20-day EMA - (10-day ATR x2)

When compared to Bollinger Bands, the Keltner Channels are typically tighter, making them suitable for spotting trend reversals and overbought/oversold market conditions. They also provide these signals earlier than Bollinger Bands would. However, the KC does not represent market volatility as well as the BB, which has wider and more explicit movements due to its use of standard deviations. Additionally, BB is less likely to produce fake signals due to its wider width. While BB is more popular, both indicators have their uses in short-term trading setups and can be used together to provide more reliable signals.

Conclusion

Overall, the Bollinger Bands indicator can be a valuable tool for traders to analyze market volatility and identify potential buying or selling opportunities. However, it should not be used in isolation and should be combined with other technical analysis methods to generate more reliable signals. The Keltner Channels indicator is a useful alternative to the Bollinger Bands, but both have their strengths and weaknesses. Ultimately, traders should carefully consider their trading strategies and goals when deciding which indicator to use.