Bollinger Bands were first developed by John Bollinger in 1980. This technical indicator measures volatility and relative over-and under-valuation of price based on moving average data plotted based on standard deviations. The band consists of the upper and lower lines on the graph. In general, bands widen with increased volatility and converge with reduced volatility.
What are Bollinger Bands?
The bands are three basic trendlines. A moving average and a low and upper band. Each of these trend lines can be adjusted as necessary. Before adjusting a band it is important to know what moving average to use. The four best examples for bitcoin are the 21 week moving average for long-term Bitcoin trades, and the 8 week moving average for short-term trends. The 50, 100, and 200 week moving averages also have some interesting price history correlations.
Once the moving averages are adjusted it is also necessary to adjust the standard deviations or the upper and lower bands. This is because more or less price data affects how often the price will remain within the bands.
Typically, the price should remain approximately 90 percent within the bands. Generally, the 10 day moving average is 1.5 standard deviations between the mean; the 20 day moving average is set at 2 standard deviations between the mean, and the 50 day moving average is set at 2.5 standard deviations between the mean. Standard deviations help to determine the variance (or spread) of an average. It uses the data set to measure the value, which is why it is often used for statistics. Knowing the standard deviation of price data can help to give clues to when price action shifts.
To make things simple, the standard deviation is calculated by square rooting the difference between the plot point and the mean (average). This helps to measure statistically significant changes. Scientific studies use this metric often and it is widely accepted that over 0.5 standard deviations above the mean are a statistically significant change. This means that all data points are calculated with equal weight. This means that the metric does not take into account more recent data that may be more significant.
Bollinger (the person) took this calculation and started experimenting with it. In general that habitual use of the Bollinger Band is the 20 week moving average with the upper and lower bands set at 2 standard deviations above and below the mean (in this case the moving average).
One of the main advantages and disadvantages of moving averages is that it is an indicator that is backward-thinking. They don’t try to guess where the price is headed and only show that the price is below or above the mean based on a particular dataset. Adding in upper and lower ranges helps because it shows how under- or overvalued the price is and gives a bit more details as to where the price could potentially go. This is because roughly 90 percent of the data is contained in the band. If the price goes below or above the band then it is possible that it will not stay that way for long.
The main strategy used is when the bands come close together. This is generally called a squeeze because the bands are squeezing up against the moving average which means that there is a small range between the standard deviation above and below the mean. Generally, this indicates increased volatility in the future. In the reverse case, the wider the bands move apart from one another, the likelihood there is for decreased volatility. This indicator does not attempt to show in what direction these potential moves will do in the future, only that a move could potentially happen, whether or not it breaks up or breaks down.
Since 90% of the time price moves between the bands, it is reasonable to expect that when the price reaches the upper or lower bands there is potential for the price to reverse or diminish its volatility before continuing on the trend. Unfortunately, the bands only give an indication as to what may happen. There are certain times when even if the price goes above the Bollinger band it will not reverse in trend, therefore it is important to think of all possible scenarios as plausible.
This does not mean that trading within the bands is a bad idea, in fact, many people who use Bollinger bands do just that. It just means that high volatility happens, or in the case of a short-term bull or bearish cases might not conform well based on a standard deviation of a data set because of other factors involved. One of the other main points to keep in mind is that, once again, Bollinger bands use moving averages. The more information the dataset has, the more accurate it will be. Therefore Bollinger bands are more appropriate for longer-term moves.
Other strategies that are frequently used are double bottoms in the Bollinger bands. In other words, the price of the asset hits the bottom of the band twice. This is not to be confused with the price. The price of the lower band could very well have changed because as we have seen everything about this metric is based on moving averages.
The last noteworthy strategy is to enter in a position if the price is holding support at the moving average that is being referenced. This may indicate momentum and (obviously) indicates that the asset is moving up.
As we have seen, the Bollinger band is an indicator that uses moving averages. This means that it is focused on past events rather than future possibilities. Therefore it is strongly recommended by Bollinger himself to use other indicators that do not correlate with it. Using indicators with other variables such as the MACD (Moving average divergence/convergence), the RSI (relative strength index), and volume are ways to add in new information to reduce false positives and help determine the particular trade an individual is engaged in.