- Type of Indicator: Volatility
- Creator: John Bollinger
- When Created: 1980s
- First Mentioned In: Bollinger on Bollinger Bands by John Bollinger.
What Are The Bollinger Bands?
Bollinger Bands are an advanced technical analysis tool created in the 1980s by John Bollinger. It consists of a set of three lines that are plotted on a cryptocurrency’s price chart. It is a trend-following tool, volatility-measuring indicator, and breakout-style trading system in one.
The middle line, also called the basis line, is a 20-period simple moving average. The upper and lower lines are calculated based on a standard deviation of price from the moving average. The standard deviation is set to 2 by default.
How Do You Read The Indicator?
The Bollinger Bands expand and contract based on the volatility of the cryptocurrency being analyzed. When the price is moving in a relatively narrow range, the bands contract. When the price is moving in a wider range, the bands expand.
If the Bollinger Bands reach the tightest level in six months, then begin to expand, this is referred to as a Squeeze. Squeezes can be prone to a “head fake” – a situation where price moves in one direction, then reverses in the real direction of the new trend.
In addition, the upper and lower bands can be used to gauge when an asset is overbought or oversold on a relative basis. Specifically, the Bollinger Bands work well with Merrill’s W and M patterns.
How Does The Tool Work?
Bollinger Bands work by calculating a 20-period simple moving average (SMA) and the upper and lower bands based on two standard deviations of price from the moving average.
The SMA can be used for trend-following, while the upper and lower bands indicate when an asset is high or low relative to normal price averages. The SMA basis and each band can act as dynamic support and resistance.
Trading signals are taken when there is a confirmed close outside of the bands. A buy signal occurs when price breaks out of the upper band on high volume. In contrast, a sell signal happens when price breaks down below the lower band on high volume. Stop losses are on the opposite side of the basis line, or at the opposite band, depending on risk tolerance.
Price movements beyond the two standard deviations is often a signal of a notable strong trend, especially when confirmed with volume-based technical indicators.
How Are The Bollinger Bands Calculated?
The Bollinger Bands are calculated using the following formula:
Middle Band = 20-period simple moving average
Upper Band = Middle Band + (2 x 20-period standard deviation)
Lower Band = Middle Band – (2 x 20-period standard deviation)
How Do You Use The Bollinger Bands?
Volatility Identification: The bands can be used to identify the volatility of a cryptocurrency. When the bands are narrow, it indicates low volatility, and when the bands are wide, it indicates high volatility.
Overbought and Oversold Levels: The upper and lower bands can be used to identify potential overbought and oversold levels. The upper and lower bands provide a “relative definition of a high and low.”
Dynamic Support and Resistance: To use the tool for dynamic support and resistance, traders can look for price reactions at the bands.
Volatility Breakout Trading Signals: Since most price action take place within two standard deviations, any moves beyond this threshold can signal an especially strong trend developing at the point of breakout. Thus, traders can take a long entry when price closes above the upper band, or a short position when price closes below the lower band.
What Is The Bollinger Band Squeeze?
A Squeeze according to John Bollinger, is when a period of low volatility leads to extreme tightness in the Bollinger Bands. In particular, a related tool called Bollinger Band Width (BBW) must reach the lowest point is a period of six months to be a valid Squeeze setup.
The Squeeze is based on the idea that low volatility phases begets high volatility. Any extreme tightening of the bands is a signal that volatility will return when the bands begin to expand again.
Traders should wait for a breakout either above the upper band or below the lower band before entering a trade.
What Is A Head Fake?
In John Bollinger’s book on Bollinger Bands, he exclaims “Trader’s beware!”
“There is a trick to The Squeeze, an odd turning of the wheel that you need to be aware of, the head fake.”
The head fake only appears towards the end of a valid Squeeze. Price will first stage a temporary false move in one direction, only to later reverse course and breakout in the direction of the emerging trend. Bollinger refers to this as the “real move.”
Traders must watch for the fake move to stay contained within the Bollinger Bands. This means there cannot be a breakout and close beyond the bands. Tagging the bands is okay, but falling short of the bands is more reliable. The breakout signal will reveal the direction of the “real move.”
What Is Walking The Bands?
Walking the bands is a scenario where a trending asset will stay near the upper or lower band, repeatedly tagging the band in the direction of the trend. The sustained trend is considered over when the opposite band is tagged after a period of walking the bands.
For example, if an uptrend remains above or near the upper band for an extended trend, then crosses the basis and touches the lower band, the uptrend is possibly over and a reversal could appear next.
In such cases, traders would seek to combine signals with technical indicators, or look for M or W top and bottom patterns.
Trading M And W Reversal Patterns
The Bollinger Bands continue to demonstrate its superior versatility at a technical tool, by assisting with M and W reversal patterns. In such instances, price will touch the upper or lower band on the first peak or trough in the pattern. Failing to tag the upper or lower band on the second peak or trough helps to confirm the pattern.
If price continues to move beyond the bands with strength, it is a sign of continuation, not a reversal. Thus, the second band tag failure is necessary to confirming these price pattern
Additional Trading & Risk Management Tips
Patience is essential when using this tool. Wait for the price to definitively break above or below the bands before entering a trade. There can be false signals while the price trades between the bands.
Protect your capital through proper risk management. Factor in more than just the Bollinger Bands when making trading decisions. Incorporate non-correlated indicators like volume and sentiment as well.
Backtest the effectiveness of Bollinger Bands for your trading style before using them live. Use historical data and a demo account. Focus on optimizing the settings and signals for your market conditions.
Finally, practice integrating the bands into a trading strategy on TradingView account. This will help determine if they improve your actual trading performance over time.