Bollinger band is a trading indicator created by John Bollinger in the 1980s for analyzing stocks and has remained as one of the most common price analysis tools since then. It’s currently used by crypto traders to discover opportunities that helps to identify when an asset is oversold or overbought.
How To Calculate Bollinger Bands
In order to calculate Bollinger Bands. We need to calculate standard deviation first.
- Find the average closing price (mean) for the periods under consideration (the default setting is 20 periods)
- Find the deviation for each period (closing price minus average price)
- Find the square for each deviation
- Add the squared deviations
- Divide the obtained sum by the number of deviations
- You can finally calculate the standard deviation as the square root of the value arrived at in the previous step.
Bollinger Bands consist of 3 simple calculations:
- The first or middle Bollinger Band is a simple moving average (SMA) of the closing price. For example, to calculate a 20 period simple moving average you add up the closing prices of an asset for 20 consecutive days and divide that value by 20.
- The second line is the upper Bollinger Band. To calculate the upper Bollinger Band you calculate the simple moving average of the Close and add Standard Deviations to it. For example the upper band formula would be MOV20+(2*20Standard Deviation of Close).
- The third line is the lower Bollinger Band. To calculate the lower Bollinger Band you calculate the Simple Moving Average of the Close and subtract Standard Deviations from it. For example the lower band formula would be MOV20-(2*20Standard Deviation of Close).
Understanding The Concept of Bollinger Bounce and Bollinger Squeeze
Two of the most important trading systems associated with Bollinger Bands are Bollinger Bounce and Bollinger Squeeze. Bollinger Bounce is a trend reversal strategy which is based on the belief that the price of a given asset tends to bounce back to the middle whenever it touches one of the bands. Thus, when the price touches the Bollinger Bands’ upper line, traders would usually go short, and vice versa.
Look at the bands as dynamic support and resistance levels. The relevance of the bands increases with larger timeframes. Hence, this strategy is suitable for swing traders who often leave their positions open overnight.
Limitations of Bollinger Bands
Bollinger Bands are not trading indicators that work alone. They are simply designed to help traders with information on price volatility in a trading chart. John Bollinger suggests using them with two or three other non-correlated indicators that give more direct market signals. He advises that it is crucial to use indicators based on different types of data. Some of his popular technical indicators are moving average divergence/convergence (MACD), on-balance volume and relative strength index (RSI).