Bollinger Bands What They Are, and How to Use Them

Bollinger Bands are a vital trading tool that consists of a 20-day SMA with upper and lower bands set two standard deviations away. They help assess volatility and identify overbought or oversold conditions, offering key entry and exit signals when combined with other indicators.

Bollinger Bands are a staple tool for investors and traders looking to assess the volatility of cryptocurrencies and stocks. Created in the 1980s by financial analyst John Bollinger, these bands help determine whether an asset is overvalued or undervalued.

When you look at a stock chart, you'll see three lines moving with the price. The center line represents the stock's 20-day simple moving average (SMA), while the upper and lower bands are typically set two standard deviations above and below this middle line.

As you monitor a stock's price, you'll notice that the bands expand when volatility increases and contract when the price stabilizes. This behavior provides valuable signals: when the price approaches the upper band, it may be considered overbought, and nearing the lower band might indicate that it's oversold. These conditions can present strategic opportunities for trading.

However, it's important to use Bollinger Bands as a secondary indicator. They work best when confirming other analysis methods rather than standing alone. To make the most of Bollinger Bands, incorporate them into a broader trading strategy that includes additional forms of analysis.

Who Is John Bollinger?

John Bollinger, CFA, CMT, has significantly shaped the field of technical analysis, most notably through the creation of Bollinger Bands in the 1980s. By merging his expertise in mathematics and engineering with financial market analysis, Bollinger developed this tool to evaluate stock price volatility and trends using a moving average and standard deviation.

Bollinger Bands have since become a fundamental element in technical analysis, widely adopted by traders and investors alike. In addition to his pioneering work with Bollinger Bands, John Bollinger founded Bollinger Capital Management, a money management company. He is also recognized as a prominent commentator and analyst, providing insights into market conditions and trends.

Building Bollinger Bands

Bollinger Bands consist of three lines that reflect a security's price movements. The central line represents the intermediate-term trend, typically calculated as a 20-day simple moving average (SMA) of the closing prices. The upper and lower bands are set a specific number of standard deviations away from this SMA, usually two, creating a dynamic range around the price.

To construct Bollinger Bands, start by selecting the number of periods for both the SMA and the standard deviation calculations. Most traders use a 20-day SMA and set the bands at two standard deviations above and below the center line.

The upper band is calculated by adding two standard deviations to the SMA, while the lower band is found by subtracting two standard deviations from the SMA. As the price volatility increases, the bands will widen, and they will contract when volatility decreases.

You don't need to perform these calculations manually. Most trading platforms, such as Cryptohopper, offer Bollinger Bands as a built-in feature, allowing you to overlay them onto your price charts and trading bots effortlessly. These platforms also provide customization options, so you can adjust the periods and standard deviations to align with your trading strategy.

Because the bands are positioned two standard deviations away from the SMA, they help indicate when prices are statistically high or low. When the price approaches the upper band, it is often considered overbought, suggesting a potential price decline and a possible resistance level where sellers might enter the market.

Conversely, when the price nears the lower band, it is typically seen as oversold, indicating a potential price increase and a possible support level where buyers might step in.

Trading with Bollinger Bands

Using Bollinger Bands can enhance your ability to assess market volatility and pinpoint potential entry and exit points. This tool operates on the principle that prices generally stay within the upper and lower bands.

When you analyze trends with Bollinger Bands, the direction of the middle band becomes crucial. An upward-moving middle band suggests a strong uptrend, while a downward movement indicates a downtrend.

Additionally, the width of the bands provides insight into market volatility. Narrow bands signal low volatility and the likelihood of a significant price move, known as a "squeeze." On the other hand, wide bands reflect high volatility.

Identifying overbought and oversold conditions is another effective use of Bollinger Bands. If the price touches or moves beyond the upper band, it may be overbought, presenting a potential selling or shorting opportunity. Conversely, when the price touches or falls below the lower band, the asset might be oversold, indicating a possible buying opportunity.

Bollinger Bands also assist in setting price targets. For example, if the price bounces off the lower band, the upper band can serve as a potential exit point if the trend reverses. Similarly, after a price movement touches the upper band, the lower band might become a target if a reversal occurs.

The "Bollinger Bounce" strategy leverages the tendency of prices to return to the middle band. In a ranging market, traders might buy when the price rebounds from the lower band toward the middle band or sell when it drops from the upper band toward the middle band.

Understanding Price Movements Within Bollinger Bands

When you use Bollinger Bands, you're leveraging the statistical concept of standard deviation to gauge market volatility. The three lines of the bands are based on a security's price movements, with the middle line typically representing a 20-day simple moving average (SMA).

The upper and lower bands are set two standard deviations away from this SMA, which helps create a range that encompasses approximately 95% of the security's price movements over a given period. This setup is grounded in the normal distribution, where about 95% of data points fall within two standard deviations of the mean.

By positioning the bands two standard deviations from the SMA, Bollinger Bands offer a practical measure of volatility that adapts to changing market conditions. When you observe prices moving outside the upper or lower bands, it signals that the security is trading at a statistically high or low level relative to its recent price history.

This can indicate overbought or oversold conditions, respectively. However, it's important to recognize that during strong trends, prices can stay outside the bands for extended periods, reflecting sustained momentum in one direction.

Understanding What Widening Bollinger Bands Indicate

When you notice the Bollinger Bands widening, it’s a sign that volatility is increasing because the standard deviation of the price is rising. This means that price movements are becoming more significant compared to recent periods.

Several factors can cause this increase in volatility, such as economic announcements, earnings reports, geopolitical events, or sudden changes in market sentiment. As volatility rises, it presents both opportunities for substantial gains and the risk of greater losses.

Widening bands might also indicate the start of a significant price trend. With increased volatility, there’s a higher likelihood of a strong and sustained price movement in one direction. However, it’s important to confirm this potential trend with other indicators or price patterns before making any trading decisions.

After a period of contraction known as a "squeeze," if the bands begin to widen, it’s often viewed as a precursor to a breakout. While the bands themselves don’t show the direction of the breakout, you can determine the likely direction by analyzing the price’s movement in relation to the bands and other indicators.

The rise in volatility signaled by widening Bollinger Bands may also lead you to reevaluate your risk management strategies. You might decide to reduce your positions or diversify your holdings to better handle the increased risk associated with larger price fluctuations.

Understanding Tightening Bollinger Bands

When you see Bollinger Bands contracting, it indicates that the market is experiencing less volatility. Price movements become more contained, and you might notice a decrease in trading volume or market interest in the short term. This period of reduced volatility is often viewed as a time of consolidation.

Despite the lower volatility, tightening bands are frequently seen as a precursor to major price moves or breakouts. By monitoring these squeezes, you can recognize that the market is building energy for a significant change.

The longer the squeeze lasts, the more powerful the subsequent breakout is likely to be, based on the principle that periods of low volatility are often followed by periods of high volatility. However, it's important to understand that tightening bands don't indicate the direction of the breakout.

During these tightening periods, you may want to adjust your risk management strategies. This could involve tightening stop-loss orders to account for the lower volatility while preparing for a potential increase in price movement ahead.

Additionally, the contraction of Bollinger Bands may suggest that there's no clear consensus among market participants about the future direction of the price. This indecision can result in the price oscillating within a tighter range until new information arrives or the market forces a breakout.

Assessing the Reliability of Bollinger Bands

When you rely on Bollinger Bands, their effectiveness hinges on several key factors, including the specific cryptocurrency you're analyzing, the settings you choose, and the broader market context.

Different assets exhibit varying volatility characteristics, which directly impacts how well Bollinger Bands can predict price movements. For instance, cryptocurrencies that frequently experience sudden spikes or drops in volatility might not behave as expected within the bands, making it harder to rely solely on this tool for accurate predictions.

The default settings for Bollinger Bands typically involve a 20-period simple moving average (SMA) with the upper and lower bands set at two standard deviations from the SMA. While these settings work well for many scenarios, they aren't universally optimal.

Depending on your trading strategy or the timeframe you're focusing on, adjusting these parameters can enhance the tool’s effectiveness. However, making such adjustments requires a solid understanding of both the markets and the specific cryptocurrencies you're trading.

Bollinger Bands gain their true strength when combined with other indicators. Incorporating tools like volume indicators or momentum oscillators such as the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) can provide additional context and help confirm the signals generated by Bollinger Bands. This complementary approach can lead to more informed and reliable trading decisions.

It's also important to recognize that Bollinger Bands are based on the statistical concept of standard deviation, which assumes that asset price returns follow a normal distribution. In reality, financial markets often exhibit "fat tails," where extreme price movements occur more frequently than the normal distribution would predict.

These outlier situations can result in prices moving beyond the bands unexpectedly, challenging the reliability of Bollinger Bands in such instances.

Bottom Line

Bollinger Bands are a powerful and essential tool for traders and investors to assess market volatility and identify potential trading opportunities. These bands consist of a 20-day simple moving average with upper and lower bands set two standard deviations away. This structure allows traders to determine when an asset may be overbought or oversold based on its price relative to these bands.

The dynamic nature of Bollinger Bands—expanding during high volatility and contracting when the market stabilizes—provides clear signals for strategic entry and exit points. For instance, prices approaching the upper band may indicate overbought conditions, suggesting a potential sell opportunity, while prices near the lower band may signal oversold conditions, presenting a buying opportunity. Additionally, the width of the bands can hint at upcoming significant price movements or trend changes.

However, to maximize their effectiveness, Bollinger Bands should be used in conjunction with other technical indicators like the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD).

This complementary approach helps confirm signals and reduces the risk of false alarms, especially in markets with non-normal price distributions or extreme volatility. Customizing the moving average periods and standard deviation settings can also enhance their applicability to different trading strategies and asset behaviors.