What Are Bollinger Bands and How To Use Them in Trading?
Trading Analysis

What Are Bollinger Bands and How To Use Them in Trading?

Created 1d ago, last updated 1d ago

CoinMarketCap Alexandria dives into Bollinger Bands, a popular trading tool and volatility indicator that helps traders navigate the market.

What Are Bollinger Bands and How To Use Them in Trading?

Table of Contents

With hundreds of indicators to try out, deciding which indicators are right for you can be challenging. For this reason, CoinMarketCap Alexandria covers many of those indicators to help you make informed decisions. In this article, we dive into the Bollinger Bands, one of the most popular indicators in trading that is relatively simple to understand as well.

Bollinger Bands serve as a volatility indicator to help traders understand whether a market is overbought or oversold. Because of the tool’s simplicity, it has gained significant popularity in the trading community.

John Bollinger developed his namesake indicator in the early 1980s, after identifying a need for what he refers to as “adaptive trading bands”, based on his observation that volatility was dynamic, contrary to the then-popular belief that volatility is static.

Fun Fact: The name “Bollinger Bands” has an interesting background. After presenting a chart with his – at the time private – indicator in a live interview, the host of Financial News Network asked Bollinger what those lines around the price structure were. Bollinger wasn’t really prepared for this question, and so he threw out the first thing that came to mind: Bollinger Bands.

What Are Bollinger Bands?

As discussed, Bollinger Bands are a tool to measure an asset's volatility and to help understand whether a market is overbought or oversold. It uses a moving average and standard deviations to generate its output. Those standard deviations are used to paint an additional two lines that serve as overbought and oversold indicators. As a result, the Bollinger Bands expand when volatility is high and contract when volatility is low. The below chart demonstrates this well.

Most traders use the standard Bollinger Bands configuration, where the middle line uses a 20-day moving average, with the upper and lower band being calculated using the 20-day standard deviation, multiplied by two. In short, the indicator is built up as follows:

Upper Bollinger Band: 20-day Moving Average + (20-day standard deviation x 2)
Middle Line: 20-day Moving Average
Lower Bollinger Band: 20-day Moving Average – (20-day standard deviation x 2)

By multiplying the standard deviation by two, John Bollinger ensured that over 85% of the price action falls within the bands, which makes the band limits work well as indicators of overbought and oversold conditions. Nevertheless, the official Bollinger Band website states that the most effective moving average may differ per market in which it is applied.

How To Use Bollinger Bands in Trading?

Because Bollinger bands only provide insights into volatility and market conditions (overbought or oversold), it is unwise to trade based on Bollinger Bands alone. The tool does not provide sufficient information to base trades on. Instead, it is wise to combine the indicator with other forms of analysis and use Bollinger Bands as an add-on in your decision-making process.

When using the indicator, this tool can provide some meaningful insights:

If the price makes its way towards the upper band, the market is likely to be overbought, and most traders start to look for sell signals. A mix of Bollinger Band extremes with other sell signals provides reasonable confidence to sell an asset. Conversely, if the price makes its way towards the lower end of the Bollinger bands, traders often seek additional buying signals.

For example, some traders use a combination of Bollinger Bands, RSI and S&R zones.

Bollinger Bands’ expansion and contraction also present powerful signals. An expanded band shows high volatility, but this often dies down over time. While this is a trading signal that does not provide directional insight, traders can use it to short volatility or enter certain options trades that bet on decreased volatility. Conversely, contracted bands often precede a violent move, and traders can look for ways to bet on increased volatility.

These direction-neutral signals can again be combined with other indicators to analyze volatility. For example, contracted Bollinger bands, combined with a bearish MACD cross at resistance, will give you decent odds to take the bearish side of a trade.

Many traders mistakenly view breakouts from the Bollinger Bands as a signal for continuation. While this phenomenon is rare, Bollinger Band breakouts do not provide insight into future price action.

Closing Thoughts

All in all, Bollinger Bands are a great indicator to add to one’s toolbox. They provide useful insights into the volatility of an asset and can help traders determine if an asset is oversold or overbought. However, the indicator does not provide much actionable insight when used on its own.

In fact, John Bollinger himself recommends combining his indicator with two or three other indicators from different categories, stressing on the MACD indicator, a volume indicator and the Relative Strength Index.

As always, whichever indicators you use, trading decisions work best when they are made with multiple forms of analysis lined up. We wish you the best of luck in refining your trading strategies, and we hope this article proves to be useful on that journey.

Writer’s Disclaimer: This article is based on my limited knowledge and experience. It has been written for educational purposes. It should not be construed as advice in any shape or form. Please do your own research.

This article contains links to third-party websites or other content for information purposes only (“Third-Party Sites”). The Third-Party Sites are not under the control of CoinMarketCap, and CoinMarketCap is not responsible for the content of any Third-Party Site, including without limitation any link contained in a Third-Party Site, or any changes or updates to a Third-Party Site. CoinMarketCap is providing these links to you only as a convenience, and the inclusion of any link does not imply endorsement, approval or recommendation by CoinMarketCap of the site or any association with its operators. This article is intended to be used and must be used for informational purposes only. It is important to do your own research and analysis before making any material decisions related to any of the products or services described. This article is not intended as, and shall not be construed as, financial advice. The views and opinions expressed in this article are the author’s [company’s] own and do not necessarily reflect those of CoinMarketCap. CoinMarketCap is not responsible for the success or authenticity of any project, we aim to act as a neutral informational resource for end-users.
1 person liked this article