What are Bollinger Bands?
The Bollinger Bands (BB) indicator was invented in the early 1980s by John Bollinger - a trader and financial analyst. This indicator is essentially an oscillator that shows market volatility, indicating whether the market is in overbought or oversold conditions. This tool is widely used in technical analysis.
The main meaning of this indicator is to clearly show the dispersion of prices around an average value. Specifically, it includes an upper band, a lower band and a middle moving average (referred to as the middle band). The 2 outer bands are a reaction to the market's price fluctuations, expanding when the price fluctuates a lot (diverging from the middle band) and narrowing when the market is less volatile (converging to the middle band).
The standard formula of Bollinger Bands sets the middle band as a 20-day moving average (SMA), the upper and lower bands are calculated based on the relative volatility to the SMA (considered standard deviation). The Bollinger Bands indicator is normally set as follows:
Middle band: 20-day moving average (SMA)
Upper Band: 20-day SMA + (20-day Standard Deviation x2)
Lower Band: 20-day SMA - (20-day Standard Deviation x2)
The structure of the BB indicator takes the history over a 20-day period, placing the upper and lower bands at a distance of 2 standard deviations from the middle band. This ensures that at least 85% of the price data will fluctuate within those two bands, however the settings can be customized according to the needs of different trading strategies.
How to use Bollinger Bands in trading?
Bollinger Bands are not only widely used in traditional financial markets but can also be applied in cryptocurrency trading. In essence, there are many different ways to use and interpret the BB indicator, however Bollinger Bands should be avoided as a sole tool and should not be viewed as a fixed indicator for buying opportunities. /sell. Instead, it is necessary to combine BB with other technical indicators.
Following this mindset, let's take an example of what it would be like to use the BB indicator in data interpretation.
When the market price exceeds the moving average, exceeding the upper band of the BB, it can be said that the market has exceeded the threshold (overbought condition) and this forecast is quite safe. Additionally, if the market price touches the upper band multiple times, then it may have reached a fairly strong resistance level.
On the contrary, when the price of an asset in the market drops deeply until it touches or exceeds the lower band many times, it is likely that the market has reached the oversold threshold or encountered a strong support level.
From there, traders can use BB (in combination with other technical indicators) to set their buying and selling targets. A simpler interpretation of the above cases is that the market exhibits overbought or oversold conditions.
Additionally, checking whether Bollinger Bands are widening or contracting is also very useful in judging high or low volatility points. These bands will diverge from the middle band in case of large price fluctuations (expansion) or gradually converge when the price amplitude is lower (contraction).
Therefore, BB is more suitable for short-term transactions, as a tool to analyze market volatility and predict the upcoming price path. Some traders believe that when the bands expand too much, the current market trend may reach the end of the cycle or reverse. On the contrary, when the bands are too tight, the general judgment is usually that the market will have a strong boom.
When the market enters the sideways phase, the BB band tends to gradually narrow to the middle moving average. Often (but not always), low volatility and skewness are preceded by large boom periods, which tend to occur just as volatility returns.
When the market price is moving sideways, the BB tends to narrow towards the simple moving average line in the middle. Usually (but not always), low volatility and tight deviation levels precede large and explosive movements, which tend to occur as soon as the volatility picks back up.
Bollinger Bands vs Keltner Channels
Unlike Bollinger Bands which are based on SMAs and standard deviations, the modern version of the Keltner Channels (KC) indicator uses the Average True Range (ATR) tool to establish the The width of the channel is around the 20-day exponential moving average (EMA 20). Therefore, the Keltner Channel formula looks like this:
Middle line: 20-day exponential moving average (EMA)
Middle band: 20-day exponential moving average (EMA).
Upper band: 20-day period EMA + (10-day ATR x2)
Lower band: 20-day EMA - (10-day ATR x2)
Basically, the KC Indicator tends to be more narrow than the Bollinger bands. Therefore, this tool seems more suitable for judging trend reversal points and determining overbought/oversold conditions of the market more clearly than using the BB indicator. In addition, the KC indicator also often shows overbought/oversold signals earlier than BB.
However, the BB indicator tends to interpret market volatility better because the BB's expansion or contraction movements are often wider and clearer than the KC indicator. Furthermore, using standard deviation will increase the accuracy of the signals that BB represents, the width is larger so it is quite difficult for the price to exceed the threshold.
Compared to the KC indicator, BB seems to be more popular. However, both indicators have their merits - especially for short trade setups - or can also be used in combination to give more reliable signals.