What are Bollinger Bands?
Bollinger Bands (BB) were created in the early 1980s by financial analyst and trader John Bollinger. They are widely used as a technical analysis (TA) tool. In essence, Bollinger Bands work as an oscillator-meter. The indicator shows whether the market has high or low volatility, as well as overbought or oversold conditions.
The main idea behind the BB indicator is to show how prices are distributed around an average value. Specifically, it consists of an upper line, a lower line, and a moving average middle line (also known as the middle line). The two lateral lines respond to market price behavior by expanding during high volatility (moving away from the midline) and narrowing during low volatility (moving toward the midline).
The standard Bollinger Bands formula sets the middle line as the 20-day simple moving average (SMA), and the top and bottom lines are calculated based on market volatility relative to the SMA (called the standard deviation). The standard BB indicator settings will look like this:
Average line: 20-day simple moving average (SMA)
Top line: 20-day SMA+ (20-day standard deviation x2)
Bottom line: 20-day SMA - (20-day standard deviation x2)
The parameter takes into account a 20-day period and sets the upper and lower lines at two standard deviations (x2) from the mean line. This is done so that at least 85% of the price data moves between these two lines, but the settings can be adjusted to suit different needs and trading 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. Of course, there are different ways to use and interpret the BB indicator, but it should not be used as a stand-alone tool, nor should it be viewed as an indicator of buy/sell opportunities. Preferably, BB should be used in conjunction with other technical analysis indicators.
With this in mind, let's imagine how the data provided by the Bollinger Bands indicator can potentially be interpreted.
If the price breaks above the moving average and above the upper Bollinger line, it is probably safe to assume that the market is oversaturated (overbought condition). Otherwise, if the price touches the upper line several times, it may indicate a significant level of resistance.
Conversely, if the price of a certain asset falls significantly and exceeds or touches the lower line by several times, it is likely that the market is oversold or has found a strong level of support.
Thus, traders can use BB (along with other AND indicators) to set sell or buy targets. Or simply get an overview of previous points where the market has shown overbought and oversold conditions.
Additionally, expanding and contracting Bollinger Bands can be useful when trying to predict moments of high or low volatility. The lines can either move away from the average line when the asset's price becomes more volatile (expansion) or move closer to it when the price becomes less volatile (contraction or compression).
Therefore, Bollinger Bands are better suited for short-term trading as a way of analyzing market volatility and trying to predict future movements. Some traders suggest that when the lines are overextended, the current market trend may be close to a consolidation or trend reversal. On the other hand, when the lines narrow too much, traders tend to believe that the market is preparing for an explosive move.
When the market price moves sideways, the BB tends to narrow towards the conventional moving average line in the center. Usually (but not always) low volatility and tight divergence levels precede large and explosive moves that tend to occur once volatility recovers.
Notably, there is a trading strategy known as "Squeezing Bollinger Bands". It consists in finding zones of low volatility, highlighted by the abbreviation BB. The compression strategy is neutral and does not give a clear idea of the direction of the market. Therefore, traders usually combine it with other AND techniques, such as support and resistance lines.
Bollinger Bands vs. Keltner Channels
Unlike Bollinger Bands, which are based on SMAs and standard deviations, the modern version of the Keltner Channel (KC) indicator uses the Average True Range (ATR) to set the channel width around the 20-day EMA. So, the Keltner channel formula will look like this:
Middle line: 20-day exponential moving average (SMA)
Top line: 20-day EMA + (10-day ATR x2)
Bottom line: 20-day EMA - (10-day ATR x2)
Generally, Keltner channels tend to be narrower than Bollinger bands. Thus, in some cases, the KC indicator may be better suited than the BB for identifying trend reversals and overbought/oversold market conditions (more obvious signs). Also, KC usually gives overbought and oversold signals earlier than BB.
On the other hand, Bollinger Bands tend to better reflect market volatility because expansion and contraction movements are much wider and more pronounced compared to KC. Also, when using standard deviations, the BB indicator is less likely to give false signals because it has a larger width and is therefore harder to outperform.
Among these two options, the BB indicator is the most popular. But both tools can be useful in their own way, especially for short-term trading setups. In addition, they can be used together to provide more reliable signals.