The Bollinger Bands (BB) technical indicator was created in the early 1980s by financial analyst and trader1 John Bollinger. Bollinger Bands are widely used as an instrument for technical analysis, and basically work as a fluctuation meter that indicates whether the market has high or low volatility and also overbought2 or oversold3 conditions.

The main idea behind the indicator is to highlight how prices are dispersed around an average value. More specifically, the indicator is made up of an Upper Band, Lower Band and a Moving Average (or Middle Band) line. The upper and lower bands react to market price action, expanding when volatility is high (moving away from the middle line) and contracting when volatility is low (moving toward the middle line).

The standard Bollinger Bands formula defines 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 (which is referred to as standard deviation). The default indicator settings are:

  • Middle Line: 20-day Simple Moving Average (SMA)

  • Upper Band: 20-day MMS + (20-day standard deviation x2)

  • Lower Band: 20-day MMS - (20-day standard deviation x2)

The default BB setting establishes a 20-day period and sets the upper and lower bands as two standard deviations (x2) from the middle line. This is done to ensure that at least 85% of price references are moving between these two bands, but these settings can be adjusted according to different needs and strategies.

 

How to use Bollinger Bands?

Although the indicator is widely used in traditional financial markets, it can also be used in cryptocurrency trading. Naturally, there are several ways to use and interpret the indicator, but using Bollinger Bands as the only analysis instrument should be avoided and should not be considered an indicator of buying/selling opportunities. Instead, BB should be used alongside other technical analysis indicators.

With that in mind, let's imagine how we could potentially interpret the data provided by the Bollinger Bands indicator.

If the price rises above the Moving Average and exceeds the Upper Bollinger Band, we probably can consider the market to be overextended (overbought). Or else, if the price touches the Upper Band several times, it could indicate a strong resistance level.

On the other hand, if the price of a certain asset drops significantly and exceeds or touches the Lower Band several times, it is likely that the market is oversold or has found a strong support level.

With this, traders can use BB (along with other technical analysis indicators) to set their sell or buy targets. Or also to get an overview of previous points where the market had overbought and oversold conditions.

Additionally, the expansion and contraction of the Bollinger Bands indicator can be useful when trying to predict times of high or low volatility. Bands can move away from the middle line as the asset's price becomes more volatile (expansion) or move closer to it as the price becomes less volatile (contraction).

Therefore, Bollinger Bands are more appropriate for short-term trading, as a way of analyzing market volatility and trying to predict future movements. Some traders assume that when bands are expanding, the current market trend may be close to a period of consolidation or a trend reversal. On the other hand, when bands become very tight, traders tend to assume that the market is preparing for an explosive move.

When the market is flat, the BB tends to narrow towards the simple moving average line. Typically (but not always), low volatility and high levels of deviation precede large moves, which tend to occur once volatility recovers.

 

Bollinger Bands vs Keltner Channels

Unlike the Bollinger Bands indicator, which is based on SMAs and standard deviations, the modern version of the Keltner Channels (KC) indicator makes use of the Average True Range (ATR) to define the channel width around an Average 20-day Moving Exponential (EMA). Thus, the Keltner Channels formula would look like this:

  • 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 have bands closer together than Bollinger Bands. With this, it can adapt better than BB to detect trend fluctuations and overbought/oversold market conditions more clearly and obviously. Furthermore, the KC indicator usually shows the overbought/oversold signal earlier than the BB.

On the other hand, the Bollinger Bands indicator tends to better represent market volatility, since expansion and contraction movements are much broader and more explicit when compared to KC. Furthermore, using the default settings, the BB indicator is less likely to provide false signals, as its width is larger and therefore more difficult to exceed.

Between BB and KC, Bollinger Bands are the most popular. However, both indicators are good – especially for short-term trading – and can be used together to provide more reliable signals.

 

Grades

1 - Trader - person or entity that sells and buys financial assets.

2 - Overbought is a strong movement in the appreciation of an asset, being close to a reversal of the movement, signaling a risk for the investor who wants to buy.

3 - Overselling is unlike Overbuying, it is an asset that is undergoing a strong devaluation and is about to reverse the movement, signaling a risk for the investor who wants to sell and exit the operation.