Bollinger Bands: Understanding Market Volatility

Bollinger Bands are technical analysis tools used to measure market volatility and assess whether an asset is overbought or oversold.

But what does it mean to measure volatility? This characteristic can be summarised as the intensity of a security’s price fluctuation. Simply put, the more the value of an asset fluctuates (and thus changes over time), the more volatile it is. 

Having clarified this concept, we can start analysing the central topic of this article. What are Bollinger Bands, how did they come about, and how do they work? Read on to find out.

Creation

This indicator, created by the famous financial analyst John Bollinger in the 1980s, measures whether a security is overbought or oversold.

The financial analyst, thanks to the book in which he theorised this indicator ‘Bollinger on Bollinger Bands’, was awarded the Lifetime Award for Outstanding Achievement in Technical Analysis. 

What are Bollinger Bands

To understand Bollinger Bands, we can start by examining what the human eye perceives when it sees them on a chart. They are curves drawn around candles or lines describing the price movement. 

In this case, around means above and below, while the central area is usually occupied by a simple moving average. The bands, also known as envelopes, trace a range that changes according to price movements and describe the health of the asset under consideration.

A simple moving average, on the other hand, is a line representing the average price of an asset over a given period. It does this by taking into account the last price of each day considered, calculating the arithmetic mean, and updating it over time.

Bollinger Bands use another statistical measure well-known to traders but slightly more challenging to understand: the standard deviation. This value, also called the mean square deviation, measures how widely the price values of a particular asset disperse from its average. In other words, it indicates whether and how reliable an arithmetic mean is.

Having a clear understanding of these concepts, particularly the simple moving average, standard deviation, and volatility is fundamental to understanding Bollinger Bands. As already mentioned, these concepts resolve into three lines that provide traders with different signals depending on how they intersect with candlesticks or other indicators they use.

How to use them in trading

Now that you know Bollinger Bands, you should learn how to use them. There is no hard-and-fast rule that traders adhere to when looking for signals on charts using this indicator, but we can provide some general guidelines to help you better identify their purpose.

First, it is worth reiterating that the indicator consists of three lines: a simple moving average and two standard deviation projections that extrapolate data according to the value set by the user. These two envelopes form a channel, the width of which describes the degree of market volatility.

In other words, the area encompassed by the bands becomes larger as market volatility increases. A trader can interpret the movements of the envelopes in different ways. For example, he might choose to enter the market when he notices that they are gradually contracting because he expects a breakout (a strongly directional movement that ‘breaks’ one of the bands).

Another universally recognised signal is when the price rebounds over one of the bands. For example, when the price approaches the lower line, the asset in question may be oversold; therefore, it may be the right time to buy it.

Beware: Using only one indicator to plan your strategy could be misleading. Be sure to check the reliability of your thesis using other tools as well.

Conversely, the asset in question may be overbought when the upward momentum runs out, which usually happens when approaching the upper band. When this happens, other indicators or the general market situation must also highlight a possible investment thesis or corroborate it: it may be time to sell the asset in question.

Bollinger Bands: How they are calculated

Knowing the steps to calculate Bollinger Bands is beneficial for understanding what they are and, more importantly, how they work. Only in this way can one get a clear 360° view of this indicator.

As we have already mentioned, the calculation starts from the centre line, which is a simple moving average derived by arithmetically averaging the closing prices of the last n candles. 

This n-value is called the ‘period’ or ‘length’ and determines the number of periods used to calculate the central moving average of Bollinger Bands. A ‘bar’ can represent a day, an hour, a minute, or any other time interval, depending on the chart’s time scale. A larger number of bars leads to a smoother moving average and bands that adjust less quickly to price changes. A smaller number of bars makes the moving average and bands more responsive to price fluctuations.

Here is the formula for calculating a simple moving average where twenty is the number of bars or ‘period’:

Simple Moving Average (20) = (Pt + Pt-1 + … + Pt- n+19)/ 20

To obtain the other 2 lines, you have to add and subtract (add for the upper band and subtract for the lower band) to the Simple Moving Average a multiple (D in the formula) of the value of the standard deviation, the statistical measure we have already discussed and which gives an immediate sense of how well the data are distributed around an average value.

Upper Band = Simple Moving Average (20) + ( Standard Deviation x D)

Lower Band = Simple Moving Average (20) – ( Standard Deviation x D)The parameter D, called ‘multiplier’, determines how many standard deviations are used to plot the upper and lower bands of the central moving average. The multiplier then adjusts the width of the bands. A higher multiplier produces wider bands, which can be helpful in capturing price movements in a more volatile market. In comparison, a lower multiplier generates narrower bands suitable for less volatile markets.Now that you know what Bollinger Bands are and how they work, you can try Smart Trades, the automatic trading feature developed by Young Platform. This way, you gradually learn how to use this indicator with the help of the algorithm. If you consider yourself an experienced trader, you can find Bollinger Bands and a host of other indicators on our dedicated cryptocurrency exchange for professionals: Young Platform Pro.