Investing > Complete Guide to Bollinger Bands

Complete Guide to Bollinger Bands

There are a number of technical analysis tools used by serious traders—and Bollinger Bands are one of the most popular.

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Updated January 08, 2022

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What if we told you that there is a tool that would ensure every single trade you make becomes a successful one? 🏆

You unquestionably wouldn’t believe that something like this exists—and you wouldn’t be wrong. If it existed, everyone would be a millionaire, and the stock market (or any other trading market per se) would become pointless.

But, until someone creates such a tool (which we highly doubt will ever happen, and if it does, we’ll say: “Shut up, and take my money”💸), we’ll have to be satisfied with the next best thing: technical analysis.

Now, technical analysis tools aren’t the holy grail of the trading world, and they are not only available to a handful of extremely rich or knowledgeable people. In fact, everyone can use them – you just need to know how.

And while using them won’t mean that every trade you make will be 100% correct, technical analysis tools will surely give you enough input to make better and more informed choices – which is infinitely better than making blind decisions. 🦯

What’s important about them is that they help you recognize specific trends, movements and “predict” the near future. Sometimes this works out, but sometimes it doesn’t. These Indicators can highlight certain trends which are about to occur, such as higher market volatility induced by the Delta variant of Coronavirus.

Every trader has their favorite – but for the purpose of this article, we’ll stick only to Bollinger Bands. Let’s see what they are and how you can use them to improve your trading.

What you’ll learn
  • What Are Bollinger Bands?
  • How Do Bollinger Bands Work?
  • How to Read Bollinger Bands
  • Day Trading with Bollinger Bands
  • How Are Bollinger Bands Calculated?
  • Pros and Cons of Using Bollinger Bands
  • Alternatives to Bollinger Bands
  • Get Started with a Stock Broker

What Are Bollinger Bands? ❓

Bollinger Bands are not new in the trading world. We could say that they are one of the first analysis tools that traders used, and they remain popular to this date. Investors started using them in the 1980s, and ever since then, they’ve become an unavoidable part of trading.

They answer a straightforward question: “Are prices high or low on a relative basis?” They can be applied to various markets, such as forex trading, equities, futures or crypto, and can also be used in different time frames (hourly, daily, weekly or monthly)

Bollinger Bands can give you insight into whether the price is too high or too low, security overbought or oversold, or how volatility impacts the movement in the near future. Combined with other valuable indicators such as support and resistance lines, or average true ranges, Bollinger Bands play an essential role in “predicting” security movement.

Bollinger Bands Example
The asset price is usually situated between the two ‘bands’—hence the distinctive look of Bollinger Bands. Image by TradingView.

The creator of Bollinger Bands isn’t some program or an AI machine. It’s a person – John Bollinger, a world-renowned author and financial analyst whose book on Bollinger Bands has been translated into eleven languages.

Creating something like Bollinger Bands isn’t easy and takes a lot of experience. It takes even more time for the general public to accept it. But, John is a credible expert and what he says always resonates, and attracts a lot of attention. For example, his recent allegations that the world of cryptocurrencies is entering a “new regime” made many people wonder.

How Do Bollinger Bands Work? 🏗

As mentioned above, the main goal of Bollinger Bands is to indicate whether the prices are high or low on a relative basis. Volatility plays a significant role in Bollinger Bands, and based on it; the bands will expand or contract. 

Even though the price is the most essential part of security, volatility is its big brother, as it often dictates how much the price can fluctuate. For example, in July 2021, Bitcoin price soared – but there was unprecedented volatility present at the same time, so the price seemed to be going back down periodically illustratating the correlation of the two “brothers.”

Before we break down how the Bands work, it’s crucial to tackle a more important subject first. That is, the components of the Bollinger Bands.

When we talk about different tools that traders use, it’s crucial to be informed about vital expressions/phrases/indicators that are often incorporated in the tools themselves and are considered their components. This also applies to the Bollinger Bands – here’s what we mean.

Bollinger Bands Components 🧰

The main components for the analysis tool that is the star of our article are the standard deviation level and simple moving average of the price. It’s important to distinguish these two and know their key features, as that way understanding Bollinger Bands will be much easier. 

The standard deviation level indicates how dispersed data is compared to the mean. A low standard deviation tells us that the data is more “clustered” to the mean, while a high standard deviation suggests that the data is more spread out. 

Another essential part of Bollinger Bands is the simple moving average of the price (or SMA as it’s often called), which is frequently mentioned in the trading world as one of the most important indicators to keep an eye on. 

SMA is basically a number that is calculated by adding up different prices of a security during a specific time frame, and then dividing that number with the total number of the time periods which are taken into consideration. It’s actually pretty simple, as seen in the image below – it’s just the average price in a given period. 

50-day SMA
A 50-day SMA (orange) gives a good overview of price changes in a 1-year period. Image by TradingView.

Now that we got that out of the way let’s focus on the Bollinger Bands. Bollinger Bands form two bands that are placed above and below the simple moving average of the price. These bands are plotted at a standard deviation level, and they react to the volatility swings of the security – which makes them pretty powerful for trading purposes. 

You can see an example in the picture below – In this case, the Bollinger Band has a 20-day period SMA in the middle, and upper and lower bands plotted at a standard deviation level (- for lower, and + for upper).

20-day period SMA Bollinger Band
Generally, the closer the price line is to one of the bands, the more likely it is to turn around and start trending in the opposite direction. Image by TradingView.

How to Read Bollinger Bands 📰

Now that you understand how Bollinger Bands work let’s learn how to read them. After all, that’s the most important part – recognizing the signal the Bands give to you.

Sure, reading Bollinger Bands can be complex and can take quite some time to master, but we’ll give you some clear tips that you can utilize in your subsequent trading. In textbook cases, the signs we will list could indicate that the price will change in the near future.

Recognizing these signals could be vital for your investment as you would be able to seize an opportunity (or dodge a bullet) proactively. For example, Bollinger Bands could have helped you navigate a volatile market after the biggest slump of China stocks in the US since 2008.

An Important thing to note is that this tool isn’t a crystal ball and isn’t always 100% correct. Bollinger Bands are there just to aid you in your trading choices, but as with everything, they aren’t perfect – so you should be ready for mistakes. 

Different Signs 👌

Okay, so we said that Bollinger Bands depend a lot on volatility. The bands will contract or expand as the price action of security becomes volatile. One of the main unique concepts for Bollinger Bands is that periods of high and low volatility usually follow each other.

period of low volatility
A period of low volatility is often a gateway to a period of higher volatility and vice-versa. Image by TradingView.

 This is important because when the trader sees the bands starting to pinch together, they can assume that volatility will increase soon – which could signal a trading opportunity. In contrast, if the two bands go further away from each other enough, it’s a potential sign that soon, volatility will drop – and the bands will move closer again. 

Another concept specific to Bollinger Bands is when the price of the security moves beyond upper or lower barriers. In 90% of cases, the price will be within the bands, but if it goes “out,” it could be a clear indicator for movement which is about to happen.

Band Breakouts with Strong Price Corrections
In most cases, a breakout signals that a price correction is iminent. Image by TradingView.

When the price of a security moves above the upper band (breaks out), it’s a signal that an asset is overbought – if that’s the case, a “pullback” is what usually occurs next. 

On the other hand, if the price moves below the lower band, it is thought that an asset is oversold, which should trigger a buy signal. Unjustifiably high or low prices represent perfect trading opportunities that every trader should be aware of.

Now, as we mentioned before, Bollinger Bands aren’t perfect, and you shouldn’t act solely based on them. But, combined with other indicators, they can help you decide when to buy and when to sell stocks.

How to Use Bollinger Bands When Day Trading ☀️

When it comes to day trading, any technical indicator can be a double-edged sword – if you know what you’re doing, your risk will pay off, but if you don’t, be prepared for a blow to your pocket.

With the increased popularity of cryptocurrencies and trading in general, many beginners are diving into day trading without knowing that they need experience before they can become profitable. Experts say that new traders will lose far more money than they will make in day-to-day trading in most cases, which is something to keep in mind. 

Regardless, it’s common for traders to use Bollinger Bands for day trading. We mentioned in the previous section one concept of Bollinger Bands which is important – when the price goes beyond or above the Bands.

false positive band breakouts
Band breakouts can be false positives or set the trader on a wrong path—this is especially true during strong bull and bear runs. Image by TradingView.

It’s a signal that the security is overbought or oversold, and in day trading, it’s something you should keep close attention to. This “crossover” might not happen daily, but when it does, you’ll be happy you recognized it on time.

Another concept of Bollinger Bands which we mentioned (when the bands go further away from each other or come close together), doesn’t apply to day trading, as it can take weeks or months for that specific chart situation to form. The Bands are commonly used to gauge mid to long-term volatility trends.

How Are Bollinger Bands Calculated? 🤓

Although technical details of a complex mathematical calculation such as Bollinger Bands can be tedious, we do think it’s important that you know the basics of how this analysis tool calculates its results. Don’t be afraid; you don’t need an A in maths to understand all of this. 

As we said, Bollinger Bands are composed of three lines – the middle line (which resembles the SMA, and the upper and lower line, which are plotted at the standard deviation level. 

In most cases, the SMA (Simple Moving Average) line is calculated on a 20-day average. The upper and lower lines are formatted by adding/subtracting double daily standard deviation to the value of the SMA line. And that’s about it.

Was this calculation complex? We don’t think so. Was it extremely fun? We know it isn’t. Let’s move on to something more interesting. 

Advantages and Limitations of Using Bollinger Bands 👍👎

While they are undeniably extremely powerful and have their advantages, Bollinger Bands also have their limitations. We said that using the Bands, you can recognize whether the security is overbought or oversold.

Looking at cryptos like AVAX, which had seen its price double in one week in August 2021, Bollinger Bands tell us that this particular cryptocurrency was in the “overbought” zone and that we should’ve expected a correction. Compared to someone who isn’t using Bollinger Bands in their technical analysis, it’s obvious who has the advantage.

On the other hand, it’s worth mentioning the limitations of this tool. As with most technical analysis indicators, Bollinger Bands are considered to be reactive and not predictive. This means that the bands will react to subtle price movements, but that they won’t predict prices. As we said, it isn’t a crystal ball. We could say that the Bands are, therefore, “lagging”.

Another limitation is that there isn’t a standard setting of Bollinger Bands for every trade. Sure, for example, 20 day SMA will work for most people, but there are situations where you would need to customize the indicator for it to work in another setting. 

This is sometimes a downside, as you would need certain trading knowledge and experience to adjust the indicator to work the way you want – and that can be a deal-breaker for a newbie trader. Also, depending on whether you use the Bands on Forex, stock, or cryptocurrency charts, you might need to change things up a bit.

Pros

  • Gives clear signals for buy/sell opportunities
  • Easy to use
  • One of the main indicators traders use for finding overbought/oversold assets

Cons

  • Customizations needed
  • Lagging indicator
  • It’s not perfect and it needs other indicators to draw a better image of an opportunity

Alternatives to Bollinger Bands 💸

Bollinger Bands aren’t the only technical analysis tool that traders use. They undeniably give the trader valuable information, but other indicators are also worth mentioning.

You may be thinking – are these indicators really necessary? Would I be able to see specific trading opportunities without them? You may be if you’re experienced enough. But the truth is that even experienced traders use these indicators, so why wouldn’t you?

RSI (Relative Strength Index), similarly to Bollinger Bands, shows you when a currency is oversold or overbought. It’s a neat indicator to have near if a reversal on the market is about to take place.

Bollinger Bands multiple indicators
Using multiple indicators together is a good way to strengthen your predictions. Image by TradingView.

Using the RSI together with our favorite bands is helpful because you can double-check whether something is overbought or oversold with an indicator that uses a different analysis methodology. Generally, relying on two metrics instead of one will give you a higher chance of only picking profitable trades.

MACD is another valuable indicator worth mentioning as it uses moving average as its engine – the same as Bollinger Bands. It stands for Moving Average Convergence Divergence, and it’s used to show the relationship between 12 and 26 period EMA (Exponential Moving Average). 

As you can see, some Indicators are similar to Bollinger Bands and have almost the same components. However, that doesn’t mean that you can’t use them simultaneously. Even better, consulting more indicators is always good practice if you want to support your decision.

Conclusion 🏁

Trading can often be highly confusing to beginners, and adding more information on top of all that, such as Bollinger Bands, can become overwhelming. But, with the right attitude, and a wish to learn and make yourself a better trader, nothing is hard. 

Keeping a healthy mind and understanding trading psychology is important, but what’s even more important is having specialized tools that will aid you in making a good trading decision. After reading this article, we hope you understood why Bollinger Bands are one of the most popular indicators in the trading world and why they are so helpful.

What’s left to do on your behalf? Study them, practice on a demo account, read literature or return to this article several times if you need to, and you’re good to go. Of course, becoming an expert will take a lot of time, so it’s better to start practicing sooner rather than later.

Bollinger Bands FAQs

  • What Do Bollinger Bands Show?

    Bollinger Bands are used to show the trader whether a security is overbought/oversold and to possible future volatility spikes which may occur.

  • What Happens When Both Bollinger Bands Open Up?

    If the bands open up, it’s an indicator that the volatility increased.

  • What are the 3 Bollinger Bands?

    The 3 bands represent: 1 - Simple moving average, 2- Upper band (double standard deviation added to the value of SMA), 3- Lower band (double standard deviation reduced from the value of SMA)

  • How Do You Spot a Bollinger Squeeze?

    A clear sign that the Bollinger Squeeze occurred is that the two outer bands come close to one another.

  • What is the Best Setting for Bollinger Bands?

    The setting which is usually recommended for most Situations is to set the Standard Moving Average to a 20 - day period. The outer bands will be created accordingly.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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