What are the Bollinger Bands?

John Bollinger, a financial analyst and trader, conceived the Bollinger Bands (BB) in the early 1980s, and they have since become a fundamental instrument in technical analysis. Functioning as an oscillator, these bands provide insights into the market’s volatility, indicating whether it’s experiencing high or low levels, and signaling potential overbought or oversold scenarios.

The fundamental principle behind the BB indicator is to visualize how prices disperse around an average. Specifically, it consists of three components: an upper band, a lower band, and a central moving average line (also referred to as the middle band). The two outer bands are reactive to market price action, expanding to reflect increased volatility (diverging from the middle line) and contracting as volatility diminishes (converging towards the middle line).

The standard Bollinger Bands formula sets the middle line as a 20-day simple moving average (SMA), while the upper and lower bands are calculated based on the market volatility in relation to the SMA (which is referred to as standard deviation). The standard settings for the Bollinger Bands indicator would look like this:

• 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)

The default Bollinger Bands setting utilizes a 20-day period with the upper and lower bands positioned two standard deviations (x2) from the middle line. This configuration is designed to encompass at least 85% of price data, though settings are adjustable based on specific trading needs and strategies.

How to use Bollinger Bands in trading?

While widely applied in traditional finance, Bollinger Bands (BB) are also valuable in cryptocurrency trading. It’s crucial to understand that BB should not be used in isolation or as a sole buy/sell signal, but rather in conjunction with other technical analysis indicators. Interpreting BB data can involve observing price interaction with the bands: if the price moves above the middle average and beyond the upper band, it suggests an overbought condition, or if it repeatedly touches the upper band, it may signal strong resistance. Conversely, if the price drops significantly to or repeatedly touches the lower band, it indicates an oversold market or a strong support level. This allows traders, when combined with other TA, to define entry/exit points or simply track past overbought/oversold occurrences.

Beyond price-band interaction, the expansion and contraction of the Bollinger Bands themselves offer insights into market volatility. Bands moving apart (expansion) signify increasing volatility, while bands drawing closer (contraction or squeeze) indicate decreasing volatility. This dynamic makes BB particularly suited for short-term trading, aiding in the analysis of market volatility and potential future price movements. Traders often speculate that over-expanded bands might presage a consolidation period or a trend reversal, while excessively tight bands suggest an impending sharp price move.

In sideways markets, the BB typically narrows towards the central simple moving average. A common observation, though not universal, is that periods of low volatility and tight band deviation often precede significant, explosive price movements once volatility resurges. This phenomenon forms the basis of the “Bollinger Bands Squeeze” strategy.

The Bollinger Bands Squeeze strategy specifically identifies these low-volatility zones marked by band contraction. However, this strategy is neutral regarding market direction. Therefore, traders employing the Squeeze typically integrate it with other technical analysis tools, such as support and resistance lines, to gain clearer directional insights.

Conclusion

In essence, Bollinger Bands measure volatility and identify overbought/oversold conditions through dynamic upper/lower bands around a moving average. Effective for short-term trading, they signal potential reversals and breakouts via expansion/contraction. However, BBs work best when combined with other indicators for more reliable trading decisions.