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 disperse around an average value. More specifically, the indicator is composed of an upper band, a lower band, and a middle moving average line (also known as the middle band). The two side bands react to market price action, expanding when volatility is high (moving away from the midline) and contracting when volatility is low (moving toward the midline).
The standard Bollinger Bands 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 (which is known as standard deviation). The standard setup 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)
The standard BB setup recognizes a 20-day period and sets the upper and lower bands two standard deviations (x2) away from the centerline. 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 using Bollinger Bands as a stand-alone instrument should be avoided and should not be considered an indicator of buying/selling 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 breaks above the moving average and breaks above the upper Bollinger band, it is probably safe to assume that the market is overextended (overbought condition). Or, if the price touches the upper band several times, it may indicate a significant resistance level.
In contrast, if the price of certain assets drops significantly and exceeds or touches the lower band several 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 get an overview of the previous points where the market presented overbought and oversold conditions.
Additionally, the expansion and contraction of Bollinger Bands can be useful when trying to predict times of high or low volatility. Bands can move away from the midline as the asset's price 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 volatility and try to predict upcoming moves. Some traders assume that when bands overexpand, the current market trend may be close to a period of consolidation or a trend reversal. Alternatively, when 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 shrink towards the simple moving average line in the middle. Typically (but not always), low volatility and tight deviation levels precede large, explosive moves, which tend to occur as soon as volatility picks up.
Bollinger Bands vs Keltner Channels
Unlike Bollinger Bands, which are based on SMA and standard deviations, the modern version of the Keltner Channels (KC) indicator uses the average true range (ATR) to set the channel width to a 20-day exponential moving average. (EMA). Therefore, 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 ATR x2)
Typically, the Keltner Channels 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. Furthermore, the KC indicator usually provides the overbought/oversold signal prior to BB.
On the other hand, Bollinger Bands tend to represent market volatility better since the expansion and contraction movements are much broader and more explicit compared to KC. Additionally, by using standard deviations, the BB indicator is less likely to give false signals, as its width is larger and therefore more difficult to beat.
Between 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.