What are the Bollinger Bands?
The main idea behind the BB indicator is to highlight how prices are dispersed around an average value. More specifically, it is composed of an upper band, a lower band, and a middle moving average line (also known as the middle band). The two sidelong bands react to the market price action, expanding when the volatility is high (moving away from the middle line) and contracting when volatility is low (moving towards the middle line).
Middle line: 20-day simple moving average (SMA)
Upper band: 20-day SMA + (20-day standard deviation x2)
Lower band: 20-day SMA - (20-day standard deviation x2)
The setting acknowledges a 20-day period and set the upper and lower bands to two standard deviations (x2) away from the middle line. This is done to ensure that at least 85% of the price data will be moving in between these two bands, but the settings may be adjusted according to different needs and trading strategies.
How to use Bollinger Bands in trading?
With that in mind, let’s imagine how one could potentially interpret the data provided by the Bollinger Bands indicator.
If the price makes its way above the moving average and exceeds the upper Bollinger band, it is probably safe to assume that the market is overextended (overbought condition). Or else, if the price touches the upper band multiple times, it may indicate a significant resistance level.
In contrast, if the price of a certain asset drops significantly and exceeds or touches the lower band multiple times, chances are the market is either oversold or found a strong support level.
Therefore, traders may use BB (along with other TA indicators) to set their selling or buying targets. Or simply to get an overview of the previous points where the market presented overbought and oversold conditions.
In addition, the Bollinger Bands expansion and contraction may be useful when trying to predict moments of high or low volatility. The bands can either move away from the middle line as the price of the asset becomes more volatile (expansion) or move towards it as the price becomes less volatile (contraction or squeeze).
So, the Bollinger Bands are better suited for short-term trading as a way to analyze the market’s volatility and try to predict forthcoming movements. Some traders assume that when the bands are over-expanded, the current market trend may be close to a consolidation period or a trend reversal. Alternatively, when the bands get too tight, traders tend to assume that the market is getting ready to make an explosive movement.
Bollinger Bands vs. Keltner Channels
Middle line: 20-day exponential moving average (EMA)
Upper band: 20-day EMA + (10-day ATR x2)
Lower band: 20-day EMA - (10-day ATR x2)
Typically, the Keltner Channels tend to be tighter than Bollinger Bands. So, in some cases, the KC indicator may suit better than BB for spotting trend reversals and overbought/oversold market conditions (more obvious signs). Also, the KC usually provides overbought and oversold signals earlier than BB would.
On the other hand, the Bollinger Bands tend to represent market volatility better since the expansion and contraction movements are much wider and explicit when compared to KC. Moreover, by using standard deviations, the BB indicator is less likely to provide fake signals, since its width is larger and, thus, harder to be exceeded.
Between the two, the BB indicator is the most popular. But both tools can be useful in their own way - especially for short-term trading setups. Other than that, the two may also be used together as a way to provide more reliable signals.