Bollinger Bands: Backbone of Technical Analysis

Introduction

Crypto trading is replete with risks. Wild candles hunt liquidity to liquidate high-leveraged positions. Sometimes even those who are most careful find themselves in hot waters. In order to cope with such a high level of volatility and uncertainty, appropriate perusal of the situation is indispensable. Although fundamental analysis also equips you with essential knowledge about trading, it is more helpful for long-term traders. For short-term trading, technical analysis is a far better option. Technical analysis demands that you acquaint yourself with tools like Bollinger Bands.

What are Bollinger Bands?

Bollinger Bands are a technical analysis tool that consists of three lines based on average price action of a coin, and it measures price volatility and overbought as well as oversold conditions. The three lines are the guiding threshold for this kind of analysis. The middle line represents simple moving average. The upper and lower bands show standard deviations from the simple moving average.

Origin of Bollinger Bands

It was in the 1980s that an American author, financial analyst and technical trader John Bollinger devised this ingenious tool to measure market extremes and volatility. This invention was in fact an improvement of earlier models such as fixed-percentage trading bands, which were not so good at analyzing volatility. Bollinger observed that his band expands during high volatility and contracts during calmer conditions. Hence it was more reliable for assets, the prices of which experience wild fluctuations.

Using Bollinger Bands

The good news is that you do not need to draw Bollinger bands yourself. Any centralized exchange or the sites like TradingView facilitate you in this projection. All you need to do is to check the option from the tools segment and set the values. The process is quite simple. After selecting Bollinger Bands on the chart, the first step is to choose the value of the middle line, which is the moving average. By default, it is set on 20. It means that the average of last 20 closing prices will be displayed on any time frame you select. The upper and lower bands will be adjusted automatically as per the moving average value.

How Bollinger Bands Work

As mentioned earlier, the moving average value for the middle line is 20. If you select D time frame, 20 represents last twenty closing prices. When these settings are applied the formula of displayed Bollinger bands will look like the following:  

• 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)

If the settings are adjusted according to the given formula, you will have 85% of the price data moving inside the bands. The upper and lower bands tend to come closer to the SMA line when there is less or no volatility in the market. This is because the deviation is minimum. At the time of high volatility, the upper and lower bands drift away from the central SMA line.

Interpretation of Bollinger Bands Movement

Besides volatility, Bollinger Bands can also tell you whether an asset has entered the overbought or oversold territory. When the price starts moving above the central SMA line, you should conclude that the asset has entered an uptrend. However, you must exercise caution once the upper bands is breached, for it shows that a correction is imminent. When the touch and retrace from the upper band recurs, it reveals that the asset is facing a strong resistance. However, the more frequent such recurrence is, the weaker the resistance becomes and the stronger the chances of its breakage get.

Similarly, when the price of an asset dips below the central SMA line and 3 to 4 days close below that line, a downtrend is confirmed. A touch or breach of the lower band indicates that the coin is oversold in the daily time frame. If the coin touches and rebounds from the lower band, the line becomes a support. Frequent retests may flash a sell signal as the support gets too weak when touched more than 3 times.

Limitations of Bollinger Bands

Despite being a very useful tool in technical analysis, Bollinger Bands are not without their limitations.

Unsuitable for Long-Term Trades

First of all, they are not suited for long-term trades. As per given formula, default value of Bollinger Bands is 20, which means that this tool is best suited for trades that last up to 3 weeks. The problem in its use in swing trades or long-term spot holdings is that these trades can be affected by fundamental macroeconomic factors far more than technical analysis. For instance, recent tariff war has turned all technical analysis topsy-turvy. A single tweet from Trump or any of his counterparts in the world shakes the whole market.

Delayed Signals

Moreover, although coming closer of the upper and lower bands indicate calm market environment, many analysts believe that such situations are precursor to explosive movements. Ironically, when such explosive movements take place, the upper and lower bands do move away from the central SMA line, yet it is too late to react for traders. The point is that the lack of volatility must be taken as a preparatory phase of the next wild wicks rather than luxury and comfort seeking zone. The direction of these weeks can hardly be predicted but overall trend on the high time frame must be taken as a point of reference.

Limited Use without Combination

Limited stand-alone use of Bollinger Bands is observed among the professional traders. Experts mostly combine Bollinger Bands with other TA indicators such as support and resistance, exponential moving averages, relative strength index (RSI) and moving average convergence divergence (MACD). The combination of these tools support and verify each other’s signals.

Conclusion

In short, Bollinger Bands are very popular among investor for the tool’s ability to measure volatility and over-bought or over-sold condition of an asset. This tool consists of three lines, of which the central line shows moving average for a time frame you choose. The upper and lower bands show deviations as set by the user. Although the tool is very useful, it is mostly used in combination with other tools used in technical analysis.