Bollinger Bands ® Analysis Explained : Price Analyses

Bollinger Bands ® Analysis Explained

Bollinger Bands are a volatility oscillator that can help you set buy and sell orders. The indicator shows you the upper, lower, and average limits of the charted price.

Bollinger Bands consist of three lines: an upper, a middle, and a lower. The middle line is the moving average (or the mean) of the prices.

Alongside the RSI, MACD and pivot points, I find that Bollinger Bands are among the most common trading indicators.

The distance between the two bands is determined by the standard deviation of price. Standard deviations are measurements for how spread out (volatile) prices are when measured from its average price.

The upper and lower Bollinger envelopes show you the standard deviations. You are free to choose how many deviations you’d like to set, but two deviations are the default setting. Also, you may adjust the length of the simple moving average (20 days is the default) if you’d like to experiment with different time scales.

Bollinger Bands Bitcoin

Your Bollinger Bands Quick Facts:

  • The bands are based on standard deviations and measure price volatility.
  • The bands widen and contract depending on price movement.
  • The line in the middle is the moving average of the security.
  • 95% of all the trading action occurs within the bands.

How to read and use Bollinger Bands

As you can see from the chart above, prices appear to “bounce” off the upper and lower bands in a consistent fashion. The bands can then be considered to work as dynamic support and resistance zones that change depending on price action.

The distance between the bands also tells you something. The wider apart the bands are from each other the higher the price volatility. From my experience, narrow bands mean that there is little interest from buyers and sellers which can often foreshadow a major move.

Bollinger Bands Middle Line

The middle line of the Bollinger Bands can be either a simple moving average (SMA) or exponential moving average (EMA). The EMA will be more responsive and give more signals than an SMA. The configuration is chosen by your trading software, but an EMA is the most common.

By default, the middle line will use 20 periods worth of data.

Bollinger Bands Narrowing

When the bands narrow, its a sign that there’s a fine balance between buyers and sellers along with little difference between the upper and lower standard deviations.

After the bands have narrowed for some time, it’s not unusual for a breakout to take place that can either take the form of a pullback or a rally.

Bollinger Bands Widening

When the bands widen, it’s a sign that a significant price movement has taken place which can be in either the bullish or bearish variety. After the bands widen, you can expect the bands to narrow again after the price reverts back to its moving average.

Bollinger Bands Algorithm and Calculation

The calculation for Bollinger Bands is straightforward. As we discussed previously, the middle line is the simple moving average while the upper and lower bands are set to two standard deviations of price.

To see what the calculation looks like on paper, below is a chart I found on stockcharts.com.

Source: https://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:bollinger_bands#sharpcharts_calculation

Most charting software will allow you to modify the calculations used for creating the bands. You can adjust the simple moving average either forward or backward which will impact how sensitive the bands are to changes in price. You can also adjust the standard deviation multiplier for the bands upper and lower limits.

Most of the time, however, it’s recommended to keep the calculations on their default settings. The reason being is that other traders and bots also make decisions using default settings. By following along with what the crowd is doing you can better see and go with the trend, which is a requirement for long-term success as a trader.

In an Uptrend

Bollinger Bands can help you see how strongly the asset is rising in an uptrend and if the asset in question is in overbought territory.

A move above the upper band can be considered overbought as the band is based on standard deviations; the reverse is true for when price breaks the lower band and becomes oversold.

Below are some guidelines I’ve put together for using Bollinger Bands when an asset is increasing in price.

  • Prices will generally touch or approach the upper band during strong uptrends. When this fails to happen, the trend could be in the process of reversing.
  • Pullbacks during strong uptrends are common and give buyers a chance to catch their breath. Pullbacks occur when you see a price decline after a period of consistent gains. If in an uptrend and the price is moving strongly, a pullback will usually occur near or above the moving average. If you see the price decline and then move above the SMA, this is a sign of considerable strength.
  • When the price is in a strong uptrend you should not see it touch the lower band, as this is a warning of an impending reversal.

In a Downtrend

I’ve also found Bollinger bands to be useful in assessing how quickly and severely an asset is falling in a downtrend.

Below are some guidelines for you to keep in mind when assets are falling in price.

  • A security in a strong downtrend will usually approach or touch the lower band. If, however, this fails to do so, then this may indicate that the downtrend is losing momentum.
  • During a downtrend, prices may rally over a short few bars. When the price moves strongly in one direction, the pullback will typically occur near or below the moving average line.
  • If you see the price rally above the SMA and then drop below it, this is a sign of significant weakness.
  • When prices are in a strong downtrend and touches the upper band, this is a warning sign of a reversal.

Bollinger Bands Patterns & Buy and Sell Signals

So, how can you use Bollinger Bands as part of your trading strategy? Let’s look at some signals that you can spot right away and start making use of Bollinger Bands.

Bollinger Bands Squeeze

One of the most common signals you’ll see with Bollinger Bands is named the squeeze.

As the name would suggest, a squeeze occurs whenever the bands contract tightly into a tight trading range. This signal implies a fine balance between buyers and sellers with a low amount of volatility.

After a squeeze ends, a significant price movement usually takes place that can be either to the upside or downside. You can estimate the price direction by looking at the middle line: is it going up or down?

In the above graph for litecoin, we can see two squeezes with the price forming tight trading channels.

These squeezes were followed by significant price movements to the upside. As confirmation of the signal, in both cases, the rallies were met with strong volume and prices breaking out of the upper band.

A characteristic of the Bollinger Band squeeze is that volume gets progressively smaller as the bands contract. In both instances, the volumes reduced to a granular level with neither buyers nor sellers having the upper hand.

You can think of a squeeze the same way that a tightly coiled spring stores it momentum before impact. As the trading range becomes more compressed, there’s less pressure on both the buy and sell side that allows for a major move to take place.

The longer a squeeze persists for, the more momentum a breakout will have.

You can trade squeezes by studying the declining volume levels and then trading the breakout. I find that it’s wise to wait for a couple of bars to confirm that a valid breakout has taken place before entering into a position. From there, you’ll be free to trade the new trend.

M Top

M Tops signal a reversal of the current upside trend to the downside. M tops and W bottoms are credited to Arthur Merrill who discovered 16 price patterns that follow the standard and inverse M shape.

In the example above bitcoin underwent what could have been a slight rally to the upside but ended up reversing when the Ms right shoulder failed to break out of the upper band. Due to a loss of upward momentum, the M kicked off a downward trend before finally consolidating into a tight trading channel.

An M top is a reversal pattern that warns you of a discontinuation of the current price trend. If you are going long, it’s wise to memorize the classic M top shape and recognize it on the daily and hourly charts.

An M top is completed when its right shoulder violates the support trend line. So, if you are going to short the M top, the best place to make your order is at the right shoulder, with a stop placed slightly above it.

W Bottom

W bottoms are the opposite of M tops. As another reversal signal, W bottoms change the course of price action from the downside to the upside.

In a dramatic fashion, ethereum formed a W bottom with the price moving from its resistance at the top of the band to well below the moving average. The price then broke through the top of the upper resistance band multiple times and created a new upward trend.

You use reverse strategies when trading the W bottoms compared to M tops. For maximum profit, the best place for you to place your order is before the completion of the price pattern, which occurs before the right shoulder holds above the resistance level.

Riding the Bands (Breakout)

Riding (sometimes referred to as walking) the bands involves following the price of a specific security as it continually violates its upper or lower band. These types of movements are only possible in strong trends and highly volatile environments.

NEO broke out from a continuation pattern to a breakout in the above graph. The price continually broke above the upper Bollinger band thereafter and formed a strong upwards trend.

Going long when the price moves above its upper limits is generally a safe move — especially when it is supported by strong volume. As the trend is moving strongly upwards, it’s therefore assumed that the price will continue to do so until the weight of evidence suggests otherwise.

Combining with Bollinger Width

The Bollinger width indicator allows you to better visualize the volatility in the marketplace. The indicator runs along the bottom of as its own series and moves up and down depending on the volatility and price action in the marketplace.

To give a clear example of how the band reacts to price movements, above we can see the line turn upwards as it moves in step with the expansion of the bands. The line can give us confirmation of price movements and the degree of change for price movements in the marketplace.

Bollinger Bands with MACD

A favorite chart combination is to use the Bollinger Bands together with a momentum indicator such as the Moving Average Convergence Divergence (MACD).

When you combine these indicators you get the best of both worlds: a volatility indicator based on standard deviations as well as a leading momentum indicator to anticipate turning points in the market.

An example of Bollinger Bands with the MACD is below.

You can note that the MACD gave a cross-over signal at the same time as price exceeded the top Bollinger Band, which makes sense. Bollinger Bands are nothing more than standard deviations of price. Breaking out from these standard deviations is a healthy sign for the bulls, while the inverse is also true for the bears.

Bollinger Bands and Relative Strength Index (RSI)

I find that Bollinger Bands and the RSI can be combined very effectively.

The RSI excels at charting overbought and oversold levels while Bollinger Bands help you see the volatility in the marketplace.

In the below example, we can see a strongly negative RSI reading of 22, which indicates a substantial oversold position.

Bollinger Bands RSI oversold

In an entirely different situation, NEO’s price was overbought as it continued its persistent trend to the upside, and encountered a squeeze.

Bollinger Bands Overbought

I find that the relationship between the RSI and Bollinger Bands tends to follow this relationship from experience, with substantial price moves in Bollinger Bands following the relative strength indicator.

It should be noted; however, that momentum typically leads price. So a strong RSI reading could foreshadow a higher Bollinger Band movement in the future.

You can use two additional strategies when it comes to using Bollinger Bands. The first is that you buy when price meets the bottom band and sell when it touches the moving average; this method is the most common.

The above strategy works because prices have a habit of reverting to the mean as can be seen in the graph below. The line near the middle of the graph is the mean or average of the data. Notice how the graph seems to come back to this line despite up and down swings. The same statistical technique is found in trading and is important you understand this as common behavior.

Source: Wikimedia Commons
Another strategy is to buy once the price exceeds the top of the band. You do this when anticipating a robust positive trend accompanied by volume and upside momentum.

Bollinger Bands can also be charted below the price action like this:

Another variation of the Bollinger Bands is a directed strategy.

Bollinger Bands directed strategy

As you can see above, the directed strategy can help you plot possible buy and sell zones and therefore speed up the process of making trades.

Bollinger Bands Day Trading

If you want to day trade using Bollinger Bands then you should be looking at 15 minute to 1 hour candles. It’s still worthwhile, however, to look at longer timeframes to get a feel for the long-term trend of the security in question.

Here’s how you can use the Bollinger Bands when day trading. Keep in mind that the same rules apply to day trading when you are swing trading or otherwise going long on the security.

  • When scaled down to hourly or minutely levels, it’s not unusual for the price to bounce between the two channels.
  • You can take advantage of a security’s volatility by buying when the price exceeds the moving average and selling once it reaches the top.
  • It’s recommended to use a stop-loss while day trading. A good place to set your stop is just beneath the moving average.

Bollinger Bands Scalping Strategy

One effective use of the Bollinger Bands is to follow a scalping strategy. Scalping involves aiming for small gains on each trade that can range from one percent to three percent of your total position size.

The goal of scalping is to increase your funds incrementally with each trade. Doing this with Bollinger Bands is made easier as the channels show you the upper and lower standard deviations, thus making a scalping strategy easier to execute.

Scalping is almost always done by day traders who have multiple positions open on the market.

To get started with this strategy, adjust your settings to 15-minute to one-minute candles and observe the trend. For scalping to be effective, it pays to choose a security that has an upwards trend with strong volume. Aim to make between one percent to three percent on each trade and watch your earnings increase over time.

Bollinger Bands Stop Loss

The bands can also show you where to place your stop loss as a standalone overlay. In general, it’s best to place your stop loss near the lower band.

Problems with Bollinger Bands

Prices touching either the upper or lower band alone does not constitute a signal. Additional information is required on the security’s volume, momentum, and price trend before you should enter into a position.

Bollinger Bands are only one indicator and cannot be relied upon to generate reliable signals for you. John Bollinger himself (the creator of Bollinger Bands) recommends using the indicator in conjunction with other un-correlated indicators such as momentum (MACD) and relative strength (RSI).

The Bollinger Bands also need some fine-tuning to adjust to specific securities. For example, if you’re trading a highly volatile cryptocurrency it will have a much larger standard deviation than a blue-chip stock, so getting the most out of the bands will take you a fair amount of experimentation.

Additionally, even when the indicator appears to be working as intended, the bands may still give you false signals (especially during periods of low volatility). As the band contracts, prices may bounce off the top and the bottom. This price movement is normal and should not be considered to be price signals by themselves.

In short, Bollinger Bands are not a perfect indicator; but instead a useful tool. The bands will give you reliable signals some of the time and whipsaws other times — just the same as any indicator that traders use to predict the market.

Some more things to keep in mind with using Bollinger Bands

  • When the price lines go above the band’s range, this is a strong continuation signal of the current trend.
  • When prices move close to the upper band, it signals an overbought market. When prices move near the bottom, it signals oversold conditions.
  • Prices consistently breaking out of its upper bands is a sign of strength, not weakness.
  • Bollinger Bands work best in ranging markets when there’s no clear sign of a trend in force.

Summary

Incorporating Bollinger Bands as part of your trading strategy is a powerful move. The bands can help you visualize the volatility in the marketplace and make better trades in the long-run.

As the bands are based on standard deviations, you’ll notice that they widen and contract based on price movement. Prices breaking out of the bands are signs of strength when its on the upside and considerable weakness during a downtrend.

You should always pair the Bollinger Bands with other indicators such as the RSI and MACD before entering a position. Easy trade entries and exits can be found by looking for signals such as the squeeze, W bottom, M top, riding the bands, and others.

Matthew North

I have a passion for trading, behavioral finance, technology, travel, and writing. Contact: matthew@priceanalyses.com.

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