Bollinger bands

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Bollinger bands are one of the most popular technical analysis indicators. They were created by John Bollinger in the 1980s and are used to measure volatility in the market as well as to predict how the price will move.

What are Bollinger Bands?

Bollinger bands consist of a upper and lower band that are placed 2 standard deviations away from a simple moving average – the middle band. The space between the two bands is called the Bollinger bandwidth.

Bollinger bands on Binance ETH/BTC 1h candles market.
The space between the Bollinger bands increases whenever there is strong price movement.

Bollinger bands can be used for a variety of purposes, but they are most commonly used to identify overbought and oversold conditions in the market. When the market is overbought, the price reaches the upper band. It means that prices have risen too high too quickly and may be due for a correction. On the other hand, when the market is oversold and the price hits the bottom band, it means that prices have fallen too low too quickly and may be due for a rebound. Bollinger bands can also be used as a volatility indicator. If the Bollinger bandwidth is wide, it means that volatility is high. If the Bollinger bandwidth is narrow, it means that volatility is low.

How to calculate the Bollinger bands?

The calculation for Bollinger bands is fairly simple. The first step is to calculate a simple moving average of the security’s price over a certain period of time. The most common time periods are 20 periods, 50 periods, and 200 periods. Once you have the moving average, you can calculate the upper Bollinger band by adding 2 standard deviations of the close price during the calculated number of periods to the moving average. To calculate the lower Bollinger band, you would simply subtract 2 standard deviations of the close price from the moving average.

Formula to calculate Bollinger bands

Upper Bollinger band: X-period SMA + (2 x Standard Deviation of the close price over X periods)

Middle Bollinger band: X-period SMA

Lower Bollinger band: X-period SMA – (2 x Standard Deviation of the close price over X periods)

NB: The Standard deviation is the square root of the variance. The variance is the mean of the squared difference of each value to the mean.

The Bollinger bandwidth can be used to gauge how far prices have moved away from the moving average. Bollinger bandwidth is simply the difference between the upper Bollinger band and the lower Bollinger band. The Bollinger bandwidth expands when volatility increases and contracts when volatility decreases.

An important thing to note about Bollinger bands is that they are based on historical data and do not predict future price movements. Bollinger bands can only be used to help you make informed trading decisions.

How to trade with Bollinger bands?

Bollinger bands can also be used to help you time your entries and exits in the market. For example, if you see that prices have been steadily rising and are steadily approaching the upper Bollinger band, you might want to consider selling or taking profits. On the other hand, if prices have been falling and are approaching the lower Bollinger band, you might want to consider buying or entering the market. Caution however, during high volatility periods, the price can push the upper band upwards or the lower band downwards during several candles in a row.

The Bollinger band squeeze and price breakouts

Bollinger band squeeze is a good technical indicator to use in order to find potential breakout plays in the market. Bollinger band squeezes occur when volatility falls to low levels and the Bollinger bands “squeeze” together. This signals that a breakout may be about to occur.

A Bollinger band squeeze can be traded by buying/going long when the prices break out above the upper Bollinger band or by selling/going short when prices break out below the lower Bollinger band.

An example of a Bollinger bands squeeze followed by a bearish breakout.

On the picture above drawn from Binance’s ETH/USDT market on 4h candles, we can see on the left a strong price movement, followed by a squeeze. A breakout occurs on the left, which would be a good oportunity to short the asset.

What other technical analysis indicators can be used with Bollinger Bands?

Bollinger bands can be used in conjunction with other technical indicators. Some common indicators that are used with Bollinger bands include the Moving Average Convergence Divergence (MACD) indicator and the Relative Strength Index (RSI).

Combining Bollinger bands and RSI for better trading signals

For instance, if the price closes above the upper Bollinger Band and the RSI is above 70, it is a strong overbought signal that can indicate a trend reversion. The market might enter a bearish phase. On the other hand, if the price closes below the lower Bollinger Band and the RSI is below 30, it is a strong oversold signal that can indicate a possible bullish trend incoming.

Combining Bollinger bands and MACD for better trading signals

As for the MACD, it could be used to confirm the formation of a trend after a Bollinger band squeeze. A sudden touch of the price of the upper used accordingly with an MACD cross signal can be used to enter a long position more confidently. Conversely, a price touch of the lower Bollinger band with a bearish MACD cross can be used to enter a short position.