The Bollinger Bands indicator is a technical analysis tool defined by a set of trend lines that define two standard deviations (positive and negative) from the simple moving average (SMA), but it can be customized based on user preferences. The Bollinger Bands indicator was developed and copyrighted by the famous trader John Bollinger. This indicator is designed to discover opportunities that give investors a higher probability of correctly identifying the times of maximum buying and top selling of the market.
In this indicator, three lines make up the Bollinger bands: a simple moving average (middle band) and an upper and lower band. The upper and lower bands are usually +/- 2 standard deviations from the 20-day simple moving average, but the change in trend is possible.
The first step in calculating the Bollinger Bands indicator is to calculate the simple moving average of the asset in question, which usually uses the 20-day SMA. The 20-day moving average calculates the average closing prices for the first 20 days as the first data point. The following data point subtracts the first price, adds the price on day 21, and takes the average. Then the standard deviation of the stock price is obtained.
The standard deviation measures how far the numbers are distributed from a mean value for a given data set. The standard deviation can be calculated by taking the variance's square root, the average squared difference. Then, multiply the standard deviation value by two and subtract both values from each point along the SMA. The obtained numbers indicate the position of the upper and lower bands.
The Bollinger Bands indicator is a modern technique for traders. Many traders believe that the closer the prices are to the upper band, the market is in the maximum buying mode, and the closer the prices are to the lower band, the market is in the maximum selling mode. Since standard deviation is a measure of volatility, bands widen when markets become more volatile. Conversely, during periods of less volatility, bands also decrease.
The concept of squeeze is one of the main concepts of the Bollinger Bands indicator. A squeeze occurs when the bands converge and limit the moving average. A squeeze represents a period of low volatility, and traders see it as a sign of increased future volatility and possible trading opportunities. On the contrary, the more the bands are apart, the more likely the volatility will decrease, and the more likely the exit from the trade will be. However, these conditions are not trading signals. Bands do not indicate when a change may occur or in which direction the price will move.
Almost 90% of the price action takes place between the two bands. Therefore, breaking out above or below the bands is an important event. Failure is not a trading signal. Most investors make the mistake of believing that the price rising or exceeding one of the bands will signal to buy or sell. Breaks do not provide any clues as to the direction and magnitude of future price movement.
Bollinger Bands can determine how much an asset rises and when it is potentially reversing or losing strength. For example, if an uptrend is strong enough, it will regularly reach the upper band. Conversely, an uptrend that goes to the upper band indicates that the stock is rising, and traders can use this opportunity to buy. If the price pulls back in the uptrend range, stays above the middle band, and returns to the upper band, this is a strong signal to buy the stock. However, in general, the price in an uptrend should not touch the lower band, and if this happens, it is a warning sign for a reversal or loss of strength of the stock.
Most traders aim to profit from solid uptrends before a reversal occurs. When the stock fails to make a new high, traders tend to sell the asset at this point to avoid incurring losses from the setback. Technical analysts monitor the behavior of an uptrend to know when it is showing strength or weakness and use this as a sign of a possible trend reversal.
Bollinger Bands can determine how much an asset will fall and when it will return to an uptrend. For example, in a strong downtrend, the price will move along the lower band, indicating that selling activity is still vigorous. But if the price fails to touch or drive along the lower band, it is a sign that the downtrend may be losing momentum.
When the price pulls back and remains below the middle band and then returns to the lower band, this indicates the strength of the downtrend and is a strong signal to sell the stock. Conversely, prices should not break above the upper band in a downtrend, as this indicates that the trend may reverse.
Many traders avoid trading during downtrends. A downtrend can last for a short or long time, minutes, hours, weeks, days, months, or even years. Investors should sufficiently recognize any signs of a downward trend to protect their capital. If the lower bands show a steady downtrend, traders should be cautious to avoid entering unprofitable trades.
Bollinger Bands indicator and Keltner channels are different but similar indicators. In the following, we will take a brief look at the differences between these two tools so that you can decide which one you can use better for your transactions. Bollinger bands use the standard deviation of the underlying asset, while Keltner channels use the true average range (ATR), which is a measure of volatility based on the trading range in the security. Apart from how the bands/channels are created, the interpretation of these indicators is generally the same. One technical indicator is not better than another. It is a personal choice based on which the strategies employed will have different results. Because Keltner channels use the mean true range rather than the standard deviation, it is common to see more buy and sell signals in Keltner channels than when using the Bollinger Bands indicator.
The Bollinger Bands indicator is not a standalone trading system. This indicator is designed to provide traders with information about price fluctuations. John Bollinger suggests using it with two or three other non-correlated indicators that provide more direct market signals. He believes it is imperative to use indicators based on different data types. His favorite technical techniques include Moving Average Divergence/Convergence (MACD), Balanced Volume, and Relative Strength Index (RSI). Because the Bollinger Bands indicator is calculated using a simple moving average, either older price data is treated as new data, meaning that further information may be confused with old data. Also, using the 20-day SMA and two standard deviations may not work for everyone in any situation. Therefore, traders should adjust and monitor their SMA and standard deviation assumptions accordingly.
There are several uses for the Bollinger Bands indicator, including using it for trading signals when the market is overbought or oversold. Traders can also add multiple bands to their chart, which helps highlight the strength of price action. Another way to use bands is to look for volatility contractions. Significant price drops usually follow these contractions. Also, the Bollinger Bands indicator should not be confused with Keltner channels. While these two indicators are similar, they do not perform exactly the same. The TOBTC website is an official and reliable source for providing up-to-date information about financial markets and investments in digital currency. We aim to increase investors' awareness to earn profits and avoid possible losses. You can share your questions, opinions, and suggestions with us through the comment section or on social networks.