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Whenever a trading chart is displayed, one of the first scarecrows newbies get to face is the "coloured spaghettis (that's what they really look like)" making random movements on the screen. The random lines are called **"Bollinger Bands."** Not only is the sight of it confusing, it is almost impossible, at first glance, to tell how they can be applied in trading the financial markets. This article dives deep into exploring the dynamics and application of the Bollinger Bands indicator.
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## What is the Bollinger Bands Indicator?
The Bollinger bands indicator is a technical analysis tool that was developed in 1980 by John Bollinger. It is made of a Simple Moving Average (SMA) line enveloped by two lines placed at two standard deviations above and below the SMA. These lines together form a tunnel-like band within which the price of an asset is expected to be for the most part of a trading period.
The Bollinger bands easily fit into the role of a *dynamic support and resistance* line, with the upper and lower limits mimicking major support/resistance zones, and the centerline switching between both roles as either a minor support/resistance depending on the market direction.
Usually, the Bollinger bands are defined around the 20-Day Simple Moving Average as the centerline, with the upper and lower limits derived by taking two standard deviations above and below the 20-Day Simple Moving Average. These standard deviations give off an idea of the extent to which price can go away from an average value, thus, leading to the conclusion that price will remain within the bands for 95% of the time.
### How is it calculated?
Since the Bollinger band is made of two major components- the SMA line and the Standard Deviation lines, knowing how the values behind these lines are arrived at is of importance as well.
The major component here is the Moving Average line within the upper and lower bands. From the default setting of this indicator, the Moving Average line represents the 20-Day Simple Moving Average (SMA). As the name implies, the SMA is not constant, it is recalculated for every new day. Once a trading day is over and indicated by the beginning of a new candlestick on the daily timeframe, the SMA automatically recalculates the prevailing 20-Day SMA at that time.
The SMA = the Average price of an asset in the past 20 days. This is derived by adding up the different closing prices of the asset in the past 20 days and dividing it by the number of days in consideration.
Mathematically this can be expressed as;
<center> ***SMA<sub>n</sub> = X Bar = (X<sub>1</sub>+X<sub>2</sub>+...X<sub>n</sub>)/N)*** </center>
where:
SMA<sub>n</sub> = Simple Moving Average in period "n"
X<sub>1</sub>-X<sub>n</sub> = Closing prices for periods 1 to n
N= total number of periods under consideration (20 days )
Once this is gotten, we proceed to obtain the value of the standard deviation by applying the following formula
<center> ***SD = √sum(X-SMA)<sup>2</sup>/(N-1)*** </center>
When these matrices are gotten, determining the upper and lower Bollinger bands takes the following process:
***<center> SMA + 2(SD) = Upper band
SMA - 2(SD) = Lower band </center>***
### How it works
Bollinger bands are often used as targets to determine the direction of market moves. For instance, when price moves towards the upper band, most traders are psyched to believe that there will be a reversal, so they start taking profits on their long trades and wait to initiate a sell if the reversal happens. However, what mostly happen in these zones are pullbacks.
The same applies to the lower band, which acts as a dynamic support line. It is a popular belief that sell pressure usually gets exhausted around the lower band. Hence, seeing the price go in the opposite direction after bouncing off the lower Bollinger band is no new scenario at all.
The Bollinger bands widen and contract in response to price volatility in the last 20 days as depicted by the 20-Day moving average. Periods of high volatility will see the bands get far apart from each other, while low volatility periods squeeze the bands into a narrow tunnel.
### The best Bollinger bands setup
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Based on popular usage, the best Bollinger bands setup is the one with the 20-Day SMA. As presented in the image beside this block of texts. Length= 20, Source set to "Close" and Standard Deviation = 2. this happens to be the default setting for the Bollinger bands, so there are pretty much no changes to be made, except minor personal preferences such as changing the gradient, color, sizes and texture of the bands.
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## Breakouts and how determine them?
### What is a Breakout?
Breakout, in the financial market, is a term used to describe a sudden increase in the volatility of trade on an asset. This sudden leap in volatility causes prices to make a sharp swing into one of two directions, up or down. Although breakouts can happen at any point in the market, it often follows a period of very low price momentum in the market, rightly called "ranging" markets.
Ranging markets are identified by a series of swing highs and swing lows that are inconsistent with a trend direction (up or down). In a ranging market, one could neither tell if the market is in an uptrend or downtrend. The market tends to trade sideways, making repeated movements within a price range.
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<sub>A highlighted ranging section for CAKE/BUSD pair.</sub>
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The Bollinger bands are very effective at spotting ranging markets. Due to the tunnel formed by the upper and lower bands around the 20-Day Simple Moving Average, it is easily identifiable when the market is neither moving up or down. The bands go sideways, making repeated movements around a range of prices, without making any new highs or lows.
### How to Determine a Breakout
To determine a breakout using the Bollinger bands, the following is good to note:
##### Low Price volatility
This market situation is usually seen before a major news event. It is seen as that period where traders hold their marks, waiting to jump in on the market move that will follow after the event. So, price is not as volatile as it would be if the market were to be at its optimal state.
During this period, the 20-Day SMA will be relatively flat, and the Bollinger bands will squeeze into a more narrow tunnel. This is also called a "Bollinger Squeeze." Once the squeeze is broken and volatility returns, a breakout has occurred.
##### High Price volatility around any of the Bollinger bands
As previously stated, the Bollinger bands can also function as dynamic support and resistance zones. The popular conditioning around this construct is that prices are most likely to change direction around these zones. That is, Sell/Buy pressures oftentimes get exhausted around the support/resistance zones, giving off possible hints for a trend reversal.
<center><sub>High price volatility around points 1 and 2 on CAKE/BUSD pair.</sub> </center>
However, on occasions where prices still maintain a strong momentum when approaching these zones (like in points 1 and 2 in the image above), it might be an indication that the market is about to experience a breakout to establish new highs or lows.
## How to use Bollinger bands in a trending market
Bollinger bands are about the easiest indicators to use in a trending market but first, *what is a trending market?*
<center>https://cdn.steemitimages.com/DQmZu52dqg8ygSnvdVZbQgEMTsFsSvDuPxgwfSsyJ1kUWiR/4.png
<sub>Screenshots showing an Up trending market and a Down trending market on CAKE/BUSD pair.</sub> </center>
A trending market describes a market with clearly defined highs and lows that are consistent with a market direction (up or down). The market, at any time, is in one of three states - uptrend (going upward with new sets of higher highs and higher lows), downtrend (going downward with new sets of Lower highs and lower lows), or ranging (going sideways or horizontal). For a trending market, the direction is either upward or downward. No sideways movement.
Using Bollinger bands in a trending market, one can determine the direction of the trend with much more ease than would have been possible using other indicators. Once the direction of the market is known by observing the direction of the Bollinger bands, a trader can then look for trades in the direction of the trend while taking critical points like the upper band, 20-Day SMA, and the lower band to time entry and exit points, check for pullbacks, trend reversal or trend continuation.
Oftentimes, the Overbought and Oversold Strategy is used by the trend riders. Using this approach, the overbought or oversold market conditions are first identified at points where the price of the asset breaks the upper or lower band of the Bollinger Bands. When the price breaks below the lower band, it is considered that the asset is oversold because the price has fallen too much and is due to bounce. On the flip side, when price breaks above the upper band, the market is said to be overbought and due for a pullback.
## What is the best indicator to use with Bollinger Bands to make your trade more meaningful?
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<sub>My ideal trade window.</sub> </center>
Personally, my ideal indicator window comprises the Bollinger bands, Support and Resistance Zones, and the Moving Average Convergence Divergence (MACD) indicator. When these indicators are coupled with price action, analyzing and taking trades becomes a lot more seamless.
I use the Bollinger bands to determine the direction of the market, overbought and oversold conditions, as well as the volatility in the market. Also, the BB serves to give information about entry or exit points, while the support and resistance zones help in defining the optimal entry or exit points according to previous price history. The Bollinger bands also signal when pullbacks, trend reversals, or trend continuations would occur.
The Moving Average Convergence Divergence (MACD) is my go-to indicator anytime I wish to confirm a possible trend reversal or continuation suggested by the structure within the Bollinger bands. This indicator comprises of the MACD line, the signal line, and histograms. The MACD and Signal lines make random crosses whenever the market is about to change direction. The length and direction of the histograms help to reveal if the force behind the move signaled by the MACD cross is sustainable.
When these indicators are used together with the leading price action, predictions of price movements can be done with a greater level of accuracy. For instance, the credibility of signals from the price action within the Bollinger bands can be promptly verified on the MACD indicator plane, and proper entry or exit can be gained around support and resistance zones. Consequently, possible fake-outs or false signals can be spotted before they even play out.
## What timeframe do the Bollinger Bands work best on? And why?
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<sub>Showing the 1-day, 4-hour and the 1-hour timeframes on CAKE/BUSD pair.</sub> </center>
It is often advised as best practice to analyze trades across different time-frames. It can be deductively said here that there is no absolute correct time frame to use the Bollinger bands. As traders differ in their style of trading, so should the time frame for their trade analysis. However, it is common knowledge to analyze trades across time frames that accurately represent short, medium, and long terms.
The bulk of analysis and signal finding can be done on the intermediate time-frame after getting an overall picture of the market on the higher (longer-term) timeframe, while the execution of findings, as well as finding entry and exit points are done on the lower (short term) time frame.
For instance, assuming I am a swing trader. Here is a breakdown of what my process with time-frames would look like:
First, I would draw my 20-SMA Bollinger bands on the Daily time frame and check the chart to understand the market structure and the overall market direction.
Then I'd proceed to analyze price action and indicators on the 4 hr chart, paying attention to signals that obey the market structure established on the daily chart.
Once I've gotten enough conviction about my signal, I'd move to the 1-hour timeframe to get a favorable entry point.
In summary, the time frame that works best for Bollinger bands is relative and dependent on the type of trader in question. While Swing and Long-term traders would focus more on the higher time frames ranging from 4 hours to 1 week, the Day traders and scalpers will mainly utilize the shorter time frames.
## <center> Chart Review and presentation of the various Bollinger Bands Indicator Signals </center>
<center>https://cdn.steemitimages.com/DQmYpTGTcZskq8rjG2wFV77aVg3DNjzxKYVpwZfcQPVhEJJ/6.png
<sub>Chart setup for CAKE/BUSD on the 1-day timeframe.</sub> </center>
For my illustration, I will be using the CAKE/BUSD pair. This pair is so chosen because it is one of the most traded pairs in the cryptocurrency market. My process is detailed in the steps that follow:
From my observation on the daily chart, there is a Bollinger Squeeze marked by point (1) on the chart.
There is an obvious reduction in price volatility as the Bollinger bands are contracting into a narrow tunnel. Hence, my subsequent analysis will be to determine when a breakout will happen and in which direction it would go.
At point (2), we can see the Bollinger bands beginning to expand, signaling a return of market volatility. This is as well confirmed by the MACD indicator as the histograms flip to the upside and are increasing in size.
Also, Bullish candlesticks can be seen breaking the upper band of the Bollinger bands, which is a clear indication of a potential breakout. The direction of this breakout is confirmed by the upward cross of the signal line on the MACD indicator. So we have the following signals for a breakout to the upside:
> - Bullish engulfing candles at the upper Bollinger band
> - MACD and signal lines crossover to the upside
> - Bullish(green) histograms with lengthy body sizes
By now, it is already clear that we are in for a Bull market, so I'll proceed to the 4-hour time frame to gain a favourable entry point.
<center>https://cdn.steemitimages.com/DQmacux2DWQnaxLrZDSmdVSUVDEpBaWF8yfi61eB1jBki8U/7.png
<sub>CAKE/BUSD on the 4-hour time frame.</sub> </center>
By my judgement, I'd wait for the price to test the new resistance turned support at 19.805, and rebound before I initiate a buy. Then, I'll stay in the trade until the price tests and bounces off a major resistance zone (point 2 in the image). If it bounced off resistance and breaks the 20 SMA to the downside, it is a good indication of a change in trend. We could further confirm this change in trend with the MACD below as it flips to the downside. It is best to take profits and exit the trade at this point.
So I'll have my trade Matrices as:
***<div>
Entry = Point 1
Exit = Point 2 </div>***
## CONCLUSION.
The Bollinger bands are a good tool for use in technical analysis. However, using it as a stand-alone indicator of market movements would only yield limited information about the market. When subjected to use alongside other complementary indicators across various time frames, the Bollinger bands could be the soothing balm for any trader who has grown weary of taking trades in the wrong direction.
**_Hi there! If you read to this point, I am sure you enjoyed the article. Let's take this further, I'd like to connect with you on a more personal level. Feel free to hit me up on any of my social handles below:_**
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