What Are Bollinger Bands? Definition, Purpose, Use in Crypto Trading

Bollinger Bands are popular technical indicators used by both professional and amateur traders to try to gauge an asset’s volatility and potentially predict future price movements. Developed by John Bollinger in the 1980s, many traders believe that they can be a powerful technical analysis tool in various financial markets, including cryptocurrencies. However, experts argue that while intelligent technical analysis can be a useful tool as one part of your trading toolkit, it never guarantees consistent profit.

In this guide, we’ll delve deep into Bollinger Bands, explore their applications in cryptocurrency trading, and detail their benefits and limitations. We will also tackle fundamental topics such as the definition and purpose of these bands, their origin, and historical development, as well as the key components involved in their calculation.

Finally, we’ll examine popular trading strategies based on Bollinger Bands, such as identifying overbought and oversold levels, the squeeze strategy, and their use in detecting trends and price patterns.

What Are Bollinger Bands?

Bollinger Bands are a technical indicator consisting of a central line representing a simple moving average (SMA) of an asset’s price and two additional lines: an upper band and a lower band. These upper and lower bands are plotted a set number of standard deviations (usually two) above and below the moving average.

The upper band is calculated by adding a multiple of the standard deviation to the SMA, while the lower band is obtained by subtracting the same multiple of the standard deviation from the moving average. This arrangement creates a dynamic channel that widens or narrows depending on the price volatility, potentially providing valuable insights to traders and investors.

Bollinger Bands are most commonly used to gauge an asset or market’s volatility. When the bands widen, it indicates increasing price volatility, which may signal a more active market. On the other hand, when the bands contract, it suggests a decrease in volatility and possibly a period of consolidation or sideways movement in price.

Traders also like to use Bollinger Bands to try to identify potential overbought or oversold levels. When the price approaches or exceeds the upper band, it can be interpreted as a signal of overbought conditions, suggesting that the asset may be reaching excessively high levels. Conversely, if the price approaches or falls below the lower band, it could be considered a signal of oversold conditions, indicating that the asset may be undervalued.

It’s vital to note that none of this information provides any guarantees of future price movements. Speculative markets are extremely unpredictable and many newer traders don’t understand that technical analysis is far from foolproof. While tools like Bollinger Bands can be helpful when used in conjunction with many other tools, trends, and market analyses, it’s important to remember that they don’t guarantee profits and shouldn’t be relied on by themselves.

Origin of Bollinger Bands

Bollinger Bands were developed in the early 1980s by John Bollinger, a renowned technical analyst and portfolio manager. Working as a financial market analyst at the time, Bollinger was seeking a way to enhance price volatility analysis and develop better trading strategies.

After experimenting with different approaches, Bollinger came to the conclusion that by plotting lines on a price chart at a certain distance from a moving average, valuable information about market volatility could be obtained. This observation led him to combine the moving average with standard deviations, thus creating what would later be known as Bollinger Bands.

Bollinger Bands were formally introduced by John Bollinger in a series of articles and presentations throughout the 1980s. Bollinger explained his new indicator and detailed how to use the bands to analyze price volatility and identify price extremes within current trends.

Despite their apparent simplicity, Bollinger Bands quickly gained popularity among Wall Street traders and became a fundamental tool in technical analysis. Gauging volatility is one of the most important roles that technical analysts take on, and many believe the Bollinger Bands to be legitimately helpful and intuitive.

While Bollinger Bands were initially designed for the stock market, they were quickly applied to other financial markets, such as futures, currencies, and, more recently, the cryptocurrency market. Today, Bollinger Bands are widely known and used in technical analysis, making their creator, John Bollinger, recognized as one of the most influential analysts in the field of financial trading.

How Do Bollinger Bands Work?

The calculation of Bollinger Bands involves three main components: the simple moving average (SMA), standard deviation, and a multiple of the standard deviation. Each of these components plays a crucial role in the construction and operation of the bands.

Simple Moving Average (SMA)

The simple moving average is the central line of Bollinger Bands and represents the average of the asset’s closing prices over a specific period. This period, commonly known as the “time window,” can vary depending on the trader’s preferences and analysis objectives. Typically, a 20-period window (days, hours, etc.) is used, although traders can adjust this parameter to fit their needs.

The SMA is calculated by adding together the asset’s closing prices over the selected period and dividing the total by the number of periods. For example, to calculate a 20-period SMA, the closing prices of the last 20 days would be summed, and that total would be divided by 20.

Standard Deviation (SD)

Standard deviation is one of the most common measures used in statistics, used to describe how much a set of values varies from its average. In the context of Bollinger Bands, it measures how far prices deviate from the simple moving average. In other words, it indicates how far prices are from the SMA. A higher standard deviation implies higher volatility, while a lower standard deviation suggests lower volatility.

To calculate the standard deviation, begin by computing the difference between each closing price and the SMA over the chosen period. Next, square each of these differences and sum them up. Finally, divide this sum by the number of periods and take the square root of the result to obtain the standard deviation.

Multiple of Standard Deviation (DE)

The multiple of the standard deviation determines the distance between the upper band and the lower band relative to the SMA. The most common standard setting uses a multiple of two, meaning that the upper band is plotted by adding two times the standard deviation to the SMA, while the lower band is plotted by subtracting two times the standard deviation from the SMA. However, traders can adjust this multiple according to their preferences and trading strategies.

Once these three components are calculated, Bollinger Bands are plotted on a price chart, where the central line represents SMA, the upper band is SMA + (Multiple of standard deviation × Standard deviation), and the lower band is SMA – (Multiple of standard deviation × Standard deviation).

Popular Bollinger Band Trading Strategies

Two of the most popular strategies based on these bands are the overbought and oversold strategy and the squeeze strategy.

Overbought and Oversold Strategy

This strategy is based on the concept that when an asset’s price approaches or exceeds the upper band of Bollinger Bands, it may signal that the asset is trading at relatively elevated levels compared to its current trend. Traders often think that this suggests that the asset is overbought and may be prone to a downward correction. On the other hand, when the price approaches or falls below the lower band, it can be interpreted as a signal of oversold conditions, where the asset is trading at the lower end of its recent trend.

Traders employing this strategy often aim to sell when the price reaches or exceeds the upper band, anticipating a potential downward correction in the asset. Conversely, they look to buy when the price touches or falls below the lower band, expecting an upward rebound.

It’s absolutely essential to note that overbought and oversold signals don’t always result in immediate price reversals.  In strong trends, it’s common for the price to continue to move in the same direction, even after repeatedly touching or exceeding the bands. This is why most experts suggest that traders using the Bollinger Bands should consider other factors and analyses for more reliable results.

Squeeze Strategy

The squeeze strategy is based on the observation that periods of low volatility, represented by narrowing Bollinger Bands, often precede periods of high volatility and stronger price movements.

When the bands contract and narrow, it indicates that market volatility has decreased and the price is moving in a relatively tight range. This compression of the bands is known as a “squeeze.”

Traders using this strategy aim to identify these compression periods and anticipate a breakout or expansion of the bands. When the price breaks out of the narrow bands, either above or below, it’s interpreted as a signal that volatility is increasing and a significant price movement can be expected.

Once the breakout of the narrow bands occurs, traders often look to open trades in the direction of the movement, with properly adjusted stop losses. Professional traders also use other confirmation indicators, such as trading volume or momentum indicators, to support their analysis before they start trading. Like all other technical indicators, the Bollinger Bands can lead traders astray if they don’t take into account other important factors or are simply unlucky.

Other Popular Uses for Bollinger Bands

In addition to overbought and oversold signals, some traders also like to use Bollinger Bands to try to detect trends and determine entry and exit points. If the price consistently moves along the upper band, it may indicate a strong uptrend, while if the price stays near the lower band, it may suggest a downtrend.

The indicator is commonly used in conjunction with other patterns such as “W-bottoms” and “M-tops.” These patterns can provide valuable information about possible trend reversals and help traders anticipate changes in price direction. Again, it’s important to note that no indicator or pattern is guaranteed to be accurate.

How Traders Calibrate Bollinger Bands

Bollinger Bands are quite flexible, allowing traders to choose different SMAs and standard deviation multiples to fit their trading goals and strategies. Here’s a quick overview of the most common setups that traders are using today.

• Short-term traders often set the Simple Moving Average (SMA) with a period of 10 days, accompanied by bands set at 1.5 standard deviations.
• Medium-term traders involved in swing trading can adjust their Bollinger Bands by setting the SMA with a period of 20 days, while keeping the bands at two standard deviations.
• For long-term traders focusing on position trading, they can set the SMA with a period of 50 days, with bands set at 2.5 standard deviations.

What Is the Future of Bollinger Bands?

Proponents of Bollinger Bands believe that they can be a powerful tool for traders in traditional financial markets as well as cryptocurrency trading. They believe that they can both help identify overbought and oversold levels and inform on volatility trends, providing potentially valuable information that can empower traders’ decisions and increase their chances of success in volatile markets.

Nevertheless, it’s vital to remember that when operating in any financial market, it’s crucial to carefully consider your risk tolerance and avoid relying solely on a single indicator. In the specific case of cryptocurrencies, strong risk management and disciplined execution of trading strategies are often essential to staying afloat and achieving consistent goals in this difficult environment.

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Julia Sakovich

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I’m a content writer and editor with extensive experience creating high-quality content across a range of industries. Currently, I serve as the Editor-in-Chief at Coinspeaker, where I lead content strategy, oversee editorial workflows, and ensure that every piece meets the highest standards. In this role, I collaborate closely with writers, researchers, and industry experts to deliver content that not only informs and educates but also sparks meaningful discussion around innovation.

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