Bollinger bands are a widespread type of technical analysis indicator used in trading various assets such as stocks, cryptocurrencies, indices, etc. Along with other technical tools, they help investors define overbought and oversold conditions in the market, decide on the trade entry or exit points, etc. Continue reading and find out the peculiarities of Bollinger bands, how to use them, popular patterns, limitations, and more.
What are Bollinger Bands?
Bollinger bands are a technical indicator introduced in the 1980s and named after its creator John Bollinger. In contrast to other technical tools not only can it identify if the financial instrument is overbought or oversold but also measure the level of asset volatility.
Bollinger bands consist of three lines:
- The upper band shows the overbought signal (selling trigger).
- The lower band shows the oversold signal (buying trigger).
- The middle line or middle band is usually represented by the 20-day moving average (MA).
Another key element of this indicator is a Standard Deviation which is a measurement of volatility. The number of these deviations influences the bandwidth and determines the distance between the middle band and lower/upper bands. The price move standard volatility is set to 2.
What Do Bollinger Bands Tell You?
The upper and the lower Bollinger bands form the price channel that helps traders monitor underlying asset price fluctuations. If it stays within the channel, investors understand that trading goes as expected. If the asset price gets closer to the upper band, the market is considered to be overbought, thus, traders tend to sell. If the asset price is approaching the lower band, the market is thought to be oversold, thus, investors use it as a buying signal. Here are some other points bands could indicate.
The squeeze reflects the conditions of low volatility in the market. Accordingly, the bands get tighter, moving towards the middle line. Many traders consider it as a sign of upcoming price movement in either direction. Conversely, when the volatility is increasing the bands are drifting apart. This usually defines the end of the price trend and the sign to exit the trade. However, it’s crucial to remember that bands can’t define the direction of the price moves or the time it will happen.
Although most of the time the asset price keeps floating within the price channel, it may also exceed the upper or the lower bands. Many traders mistakenly believe that this situation generates buying or selling signals. However, it could denote a strong trend only in case, the price stays out of the channel for a longer time.
How to Calculate Bollinger Bands
To calculate Bollinger bands first it’s necessary to compute the moving average (MA). The standard value is 20. After that, it’s time to calculate the Standard Deviation over the same number of periods as MA. The typical value is set to 2.0. Relying on the standard values of moving average and Standard Deviation, 20 and 2.0 respectively, the formula for the Bollinger bands is as follows:
Upper band = 20-day MA + (20-day Standard Deviation2)*
Lower band = 20-day MA - (20-day Standard Deviation2)*
Other typical values may be:
- 10-day MA, 1.5 Standard Deviation;
- 50-day MA, 2.5 Standard Deviation, etc.
Bollinger Band Patterns
Bollinger bands indicator comes with a variety of patterns that can facilitate your trading experience. Here are the most common of them.
Double bottom is an efficient strategy helping investors monitor price fluctuations and choose successful entry trade points. This pattern looks like a “W” on the chart, meaning that the asset price goes down, then shows the signs of rehabilitation, followed by another decrease. The double bottom usually indicates the end of the downtrend and the beginning of a potential uptrend in the market.
One of the ways to understand the buying signal is to draw the line touching the middle peak of the “W” and wait for the asset price to break it out. However, using Bollinger bands traders may identify the uptrend earlier and increase their potential profits. It’s also important to mention that if the first bottom exceeds the lower band while the second one is already inside the price channel (see the chart over), this situation may provide traders with higher chances of the coming uptrend. Although it seems easy to spot and analyze the double bottom pattern in the chart, keep in mind that everything is getting much more challenging in real-time trading.
Reversals pattern, as its name suggests, helps traders identify potential trend reversals in the asset price. This strategy is strongly related to the double bottoms/tops approach. As described above, in case the second bottom or top is located inside the lower/upper bands, while the first bottom/top is situated out of the price channel, this can be considered as a potential sign of the trend reversal, and, consequently, a potential entry/exit point.
Limitations of Bollinger Bands
Bollinger bands like any other technical analysis tool serve a particular purpose and have some limitations. Thus, before implementing this indicator in your trading strategy, make sure you are aware of them. Here are the most significant ones.
- Bollinger bands can’t help investors predict asset prices. Being a reactive tool, not a proactive one, they will only reflect the price movements in either uptrend or downtrend directions.
- To increase the efficiency and accuracy of investment decisions it’s reasonable to use Bollinger bands in combination with other technical indicators, preferably based on different types of data. These can be Moving Average Divergence/Convergence (MACD), Relative Strength Index (RSI), and others.
- Standard values of Moving Average and Standard Deviation (set to 20 and 2.0) may not be efficient in every situation. Taking into account the asset type, traders have to find out the values that will work best for them. Moreover, it’s necessary to keep in mind that Bollinger bands’ effectiveness may also vary depending on the market type.
- Bollinger bands may also pass investors some false signals, this way, leading to potential losses.
How to Use Bollinger Bands in Trading?
Bollinger Bands is one of the technical indicators that allow investors to monitor the price trends, identify overbought or oversold markets, define entry/exit trade points, etc. They can be implemented for charts with any timeframe. As mentioned before, traders can use standard values, however, it would be more efficient to adjust the Bollinger bands settings to the asset type, trading strategy, and style.
The core idea is that when the asset price gets closer to the upper band, traders consider the market overbought, thus, tend to sell. Conversely, if the asset price drops close to the lower band, the market is believed to be oversold, thus traders are likely to buy. However, it’s worth mentioning that to ensure the efficiency of your trading strategy it’s recommended to implement Bollinger bands in combination with other technical tools, especially the ones built on other types of data.
Moving averages are widespread trend-following technical indicators. The upward direction of the moving average indicates the uptrend of the asset, the downward direction, conversely, is considered a sign of the price decline. There is a wide choice of moving averages to implement in trading. Some of them are Simple Moving Average (SMA), Exponential Moving Average (EMA), etc.
A stochastic oscillator is a momentum technical indicator. It compares the closing asset price to a price range over a certain period. Like Bollinger Bands, it can help identify the overbought and oversold market conditions. Moreover, it’s used by many traders to spot potential trend reversals. The value of this tool may vary from 0 to 100.
Average True Range
Average True Range (ATR) is another popular indicator used by technical analysis supporters. In comparison with MA and Stochastic Indicator, ATR is implemented to measure volatility. Although it was meant for the commodity market, nowadays it has found application in other markets as well.
Keltner channels is a very similar technical tool to Bollinger Bands. It consists of three lines (upper line, middle line, and lower line). However, what makes it different is that instead of Standard Deviations this indicator uses the Average True Range (ATR) while the middle line is usually represented by the Exponential Moving Average (EMA). Moreover, Keltner Channels tend to be tighter.
Bollinger Bands are one of the popular technical analysis indicators. They allow investors to outline overbought and oversold markets, define successful entry and exit points, measure the volatility, and spot potential market reversals. However, like any other instruments, they have particular limitations. The key point to remember is that Bollinger Bands is a lagging indicator that doesn’t predict price movements but only reacts to them. Therefore, traders should use it in compliance with other tools and a well-considered risk management plan.