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Bollinger Bands: what is it and how to use it
Undoubtedly one of the phrases that are present in cryptocurrency trading (and others) is Bollinger Bands. Learning to read them efficiently will make you a master and you can anticipate price variations.
Below you will learn all about Bollinger Bands. We tell you how to use them and some tips you can get to read them.
What are Bollinger Bands?
Bollinger Bands are a popular technical analysis tool used by traders to assess volatility and identify potential reversal points on a price chart.
In practice, Bollinger Bands are used to determine whether a stock is at a high or low price for a given period of time. For this reason, they are often used in day trading and swing trading.
It should be noted that the name “Bollinger Bands” is in honor of their creator, the American financial analyst and technical analysis expert John Bollinger.
Usually, we find 3 types of Bollinger bands:
- The central band in a trading indicator is typically a moving average. Normally a 20-period simple moving average (SMA) is used, which reflects the average of the last 20 periods on a chart, showing the general price trend over time.
- To calculate the upper band, two times the standard deviation of the simple moving average is added to the value of the SMA. This helps to identify upper levels that could act as resistance in the price of the asset.
- On the other hand, the lower band is obtained by subtracting twice the standard deviation from the simple moving average, which establishes a level that could act as support, showing how far the price could go down under normal conditions.
How do Bollinger Bands work?
Bollinger Bands, both upper and lower, create a channel within which the price is expected to fluctuate most of the time. These bands provide a suggested range for price movements and are an indicator of market volatility.
When the bands are closer together, this indicates lower volatility in the asset and can be interpreted as a period of consolidation or indecision in the market. In this scenario, prices do not show a clear trend, suggesting that traders may be waiting for stronger signals before making decisions.
Conversely, when the bands move further apart, it is a reflection of increased volatility. If the bands begin to widen, with the upper and lower lines diverging, it could be an indication that a new directional trend is developing or is about to begin, either up or down.
But there is no doubt that the use of Bollinger Bands goes beyond visuals and trends. In order for you to fully master them, I recommend you to take into account the following:
1. Calculation of the bands
The initial step in calculating Bollinger Bands is to calculate the simple moving average of the security in question, commonly using a 20-day SMA.
2. Interpretations
Bollinger Bands are a very popular technical indicator. Many traders believe that the closer prices are to the upper band, the more overbought the market is, and the closer prices are to the lower band, the more oversold the market is.
3. Squeeze
Squeeze is the central concept of Bollinger Bands. When the bands move closer together, contracting the moving average, it is called a squeeze**. A squeeze indicates a period of low volatility and traders consider it a potential sign of higher future volatility and possible trading opportunities**. Conversely, the further the bands move away, the greater the likelihood of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication of when the change might occur or in which direction the price might move.
4. Breakouts
Approximately 90% of the price action occurs between the two bands. Any breakout above or below the bands is an important event to consider. But beware that a breakout is not a trading signal, this is a mistake that most people make, believing that the price reaching or exceeding one of the bands is a signal to buy or sell. Breakouts do not provide any clue as to the direction and extent of future price movement, and the following chart shows this:
How to Use Bollinger Bands ?
That's the question everyone wants to know. The upper and lower bands measure volatility or the degree of price variation over time. Because Bollinger Bands measure volatility, the bands automatically adjust to changing market conditions.
Bands tend to narrow when an index calms down and price changes are small. At other times, the bands widen as the price becomes volatile and changes become larger.
Notice how the bands contracted when BTC/ USDT traded calm and relatively stable. Then, notice how the bands expanded when the price experienced large price changes over short periods of time.
As we have told you, bollinger bands can work for the following:
Overbought and Oversold.
Most traders use this tool to be able to understand when an asset is overbought or oversold, but this approach is not foolproof, so what approach should you take?
Generally, traders define an overbought condition of Bollinger Bands when the price of the asset moves above the upper band. Conversely, the asset price can be oversold when it moves below the lower band. But here's the catch: the asset price can remain overbought or oversold for an extended period.
One thing experienced traders will do is that when applying Bollinger Bands to measure overbought and oversold conditions, they will consider the width of the bands. Avoid looking for overbought or oversold conditions when the bands are expanding. Instead, look for these conditions when the bands are stable or even contracting.
Volatility indicator
The value of the standard deviation in a price series increases as prices fluctuate more volatile and decreases when price movements are more stable. Bollinger bands use this value to determine the distance between the upper and lower band relative to the moving average: the higher the standard deviation, the wider the bands widen; when volatility falls, the bands narrow.
A sudden and drastic narrowing in the Bollinger bands can be a sign that the market is preparing for a significant price movement. The direction of such a move can be predicted by observing the position of the price relative to the moving average:
- If the price is between the moving average and the upper band, an upward movement is expected.
- If the price is between the moving average and the lower band, a downward movement is likely to occur.
This phenomenon allows traders to be alert to sudden changes in the market and adjust their strategies according to the price position within the bands.
Strength or weakness in the current price trend.
From a technical approach, and according to the definition of Bollinger bands, prices tend to be considered relatively high when they reach the upper band and relatively low when they touch the lower band.
However, it is important to note that these movements beyond the bands do not constitute trend signals in and of themselves. Rather, they serve as indicators of the strength of the current trend.
In an uptrend, as seen on some charts, price closes above the upper band are signs that upward momentum is strong. This makes sense, since the upper band is formed by adding twice the standard deviation to the moving average, implying that considerable momentum is needed to break above the upper band.
The same reasoning applies in a downtrend, but in reverse. Price weakness is reflected in successive closes below the lower band, indicating a clear downtrend.
In addition to Bollinger bands, it is always useful to supplement your analysis with additional indicators, such as the relative strength index (RSI), which helps to better visualize price trends and provides more context on possible overbought or oversold areas.
Changes in the price trend
Two magic letters are used here: W and M. What does this mean? Let's exemplify it better:
W band
Popularly known as 'double bottom'- The first key signal is when the price closes below or very close to the lower band, forming the first bottom. This is followed by a bullish bounce that takes the price towards the middle band or the moving average. The next important signal is when the price falls again, forming a second floor that is above the lower band, indicating less weakness compared to the first floor.
Finally, the signal that confirms a change in trend is a strong upward move that takes the price above the upper band, indicating a possible start of a sustained uptrend and where we can start selling.
M Band
Popularly known as a 'double top'. The first key signal is when the price closes near or just below the upper band, forming the first top. This pattern, known as an M-figure or double top, follows similar steps to the W-figure or double bottom, but in the opposite direction. Next, a bearish reaction occurs that takes the price towards the central band (the moving average).
The next step is the formation of a second top, which should be below the upper band, indicating a lower strength in the price compared to the first top. Finally, the signal that confirms a change in trend is a strong bearish move that takes the price to break the lower band, suggesting the start of a more pronounced downtrend, so it may be time to buy.
Breakouts in Bollinger Bands (or squeeze)
Bollinger Bands are a key tool for detecting periods of low volatility in the markets, typically associated with consolidation phases. Investors who trade breakout strategies look for these moments of consolidation as a signal that a new trading opportunity is about to emerge.
When Bollinger Bands are narrow, the upper band acts as potential resistance and the lower band as a support level. If price breaks above resistance or below support, it could be an entry signal for investors looking to take advantage of a consolidation breakout.
A key indication that the market could be starting a new trend is the widening of the Bollinger Bands, suggesting that price is breaking out of consolidation. Breakout traders usually wait for this confirmation before entering the market.
Although Bollinger Bands are not usually used to set price targets, when the bands stop widening and start narrowing again, they can be interpreted as possible exit signals. This phenomenon, known as the “Bollinger squeeze,” reflects how the bands “tighten” around the price prior to a major breakout.
Conclusions
In conclusion, Bollinger bands are versatile and widely used tools in technical analysis, with diverse applications for traders. Their ability to indicate increases or decreases in volatility through the widening or narrowing of the bands makes them a useful resource for anticipating market movements. Strategies such as the “Bollinger squeeze” rely on this behavior of the bands to identify possible entry or exit points in the market.
Likewise, the “M” and “W” patterns , characteristic of Bollinger theory, are relevant signals that indicate possible trend changes, either bearish or bullish, respectively. Bollinger Bands are not only used to identify trend changes, but can also be integrated with other indicators and price analysis techniques, becoming a key tool within a broader technical trading strategy.
Bollinger Bands are a valuable adjunct that, when used correctly, can provide a significant advantage when analyzing financial markets.
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- Bollinger Bands: what is it and how to use it
- What are Bollinger Bands?
- How do Bollinger Bands work?
- 1. Calculation of the bands
- 2. Interpretations
- 3. Squeeze
- 4. Breakouts
- How to Use Bollinger Bands ?
- Overbought and Oversold.
- Volatility indicator
- Strength or weakness in the current price trend.
- Changes in the price trend
- Breakouts in Bollinger Bands (or squeeze)
- Conclusions
- Keep learning 🤓