What are Bollinger Bands?
Bollinger Bands were created in the early 1980s by financial analyst and stock trader John Bollinger. Bollinger Bands are widely used as a technical analysis (TA) tool, and are essentially a volatility measuring indicator that indicates whether a market has high or low volatility as well as overbought or oversold conditions.
The main idea behind the Bollinger Bands indicator is to show how far prices are dispersed around an average value. That is, the indicator consists of an upper bar, a lower bar, and a moving middle line (also referred to as the middle line). The two sidebars respond to market price movement. They diverge when volatility is high (moving away from the middle line) and converge when volatility is low (moving toward the middle line).
The standard Bollinger Band formula defines the middle line as a 20-day simple moving average (SMA), while the upper and lower bands are calculated based on market volatility relative to the SMA (which is referred to as the standard deviation).
The standard settings for the Bollinger Bands indicator will look like this:
Middle line: 20-day simple moving average (SMA).
Upper bar: 20-day SMA + (20-day standard deviation x2)
Bottom bar: 20-day SMA - (20-day standard deviation x2)
Formulas in English:
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 settings for the Bollinger Bands indicator are based on a 20-day cycle and set the upper and lower bands to two standard deviations (x2) away from the middle line. This is done to ensure that at least 85% of the price data will move between these two bars but the settings can be adjusted according to different needs and trading strategies.
How are Bollinger Bands used in trading?
Although Bollinger Bands are widely used in traditional financial markets, they may also be used in cryptocurrency trading. But one should avoid using Bollinger Bands as a stand-alone tool and should not be considered an indicator of buying or selling opportunities.
With this in mind, let's imagine how the data provided by the Bollinger Bands indicator can be interpreted.
If the price is trending above the moving average and crossing the upper Bollinger band it is probably safe to assume that the market is at the peak of the expansion (overbought condition). If the price touches the upper bar several times it may indicate an important resistance level.
On the contrary, if the price drops significantly and crosses or touches the lower bar several times, there is a possibility that the market is either oversold or has found a strong support level.
Therefore, traders may use Bollinger Bands (as well as other TA indicators) to set their buying or selling targets or also to get an overview of previous points where the market displayed overbought and oversold conditions.
In addition, the expansion and contraction of Bollinger Bands can be useful when trying to predict moments of high or low volatility.
The bars can either move away from the middle line as the price of the asset (currency) becomes more volatile (expansion) or move towards it as the price becomes less volatile (contraction).
Therefore, Bollinger Bands are more suitable for short term trading as a way to analyze market fluctuations and try to predict upcoming movements. Some traders assume that when there is a peak in the expansion between the bars the current market trend may be close to a consolidation period or trend reversal.
Instead when the bands become very tight traders tend to assume that the market is preparing to make an explosive move.
When the market price moves sideways, the Bollinger Bands tend to narrow towards the moving average line in the middle. Usually (but not always) low volatility and narrow deviation levels precede large, explosive movements, which tend to occur once volatility returns.
Bollinger Bands vs Keltner Channels
Unlike Bollinger Bands which rely on a simple moving average (SMA) and standard deviation, the Keltner Channels Modern Edition indicator uses the Average True Range (ATR) to set the channel width around the 20-day Exponential Moving Average (EMA). So the Keltner Channel formula would look like this:
Middle line: 20-day Exponential Moving Average (EMA).
Upper channel bar: 20-day EMA + (10-day EMA x2)
Bottom bar: 20-day EMA - (10-day Exponential Moving Average x2)
Formulas in English:
Middle line: 20-day exponential moving average (EMA)
Upper channel line: 20-day EMA + (10-day ATR x2)
Lower band: 20-day EMA - (10-day ATR x2)
Typically the Keltner Channels indicator tends to be tighter than Bollinger bands and therefore may be more suitable than Bollinger Bands for illustrating trend reversals and overbought and oversold market conditions in a more clear way.
In addition, the Keltner Channels indicator usually provides an overbought and oversold signal earlier than the Bollinger Bands.
On the other hand, Bollinger Bands tend to represent market volatility better because expansion and contraction movements are broader and more pronounced when compared to Keltner Channels. In addition, using standard deviations makes the Bollinger Band indicator less likely to provide false signals because its width is larger and therefore more difficult to exceed.
Bollinger Bands are the most popular however, both indicators are good especially for short term trading tools and the two can also be used together to provide more accurate/reliable signals.