The Bollinger bands indicator is an oscillating indicator and is used to measure how volatile a market is.
They help you identify whether a price is relatively high or low compared to its recent average and predict when it might rise or fall back to that level. This will help you decide when to buy or sell an asset.
Bolling bands show overbought and oversold markets
Bollinger bands are comprised of three main bands or lines.
The central band shows the price's simple moving average. The upper and lower bands represent levels where the price is considered relatively high or low compared to its recent moving average.
The image below shows what Bollinger bands look like on a price chart:
Most of the price action is generally contained within the bands and this means they can be used to predict market reversals.
When the price reaches the upper band, the asset is trading at a relatively high price and is considered overbought. You could now look to sell the asset on the expectation that its price will fall back towards the central moving average band.
When a price approaches the lower band, the asset is trading at a relatively low price and is considered oversold. You could now look to buy the asset on the expectation that the price will go back towards the central moving average band.
Be cautious however – just because the price may reach the upper and lower bands does not mean that the price will reverse. You will need further confirmation — using, for example, candlestick patterns or another indicator – that the price is reversing before you enter into a trade.
The distance between the bands
Bollinger bands can also help you measure how volatile a market is based on the distance between the upper and lower bands. A big space between the bands indicates high volatility while a narrow space indicates low volatility.
Take a look at the chart below:
In the blue highlighted area you can see that the bands are squeezed together and that the price is not very volatile. However, when the price becomes volatile, shown in the green highlighted area, and starts rising, the bands become further apart.
Changing the Bollinger band settings
There are two different settings that you can change on the Bollinger bands indicator: the number of periods and the standard deviation.
Changing the periods
The standard setting for the Bollinger bands is 20 periods (or 20 candles). This refers to the length of time over which the indicator is calculated from the price action.
Using fewer periods
Using a smaller number of periods makes it more reactive and results in a choppier upper and lower bands. The price breaks the bands more often, giving more trading opportunities, however, it also gives more false trading signals.
In the chart below, the indicator has a setting of 10, you can see the price breaking the upper and lower bands more often:
Using more periods
Setting a higher number of periods will make it less reactive and result in a smoother lines.
The price breaks the upper and lower bands less often, giving less, but more reliable signals.
The following image shows a setting of 40 – double the standard setting of 20 periods. Notice how far apart the outer bands are compared to the previous chart and how less often the price breaks the bands:
Changing the standard deviation
The standard deviation setting of the Bollinger bands is 2.
The standard deviation refers to how much of the data from the moving average's normal distribution pattern are included in the bands.
Increasing the standard deviation increases the distance of the bands from the central line and so more of the price action is contained within them.
So, a setting of 1 standard deviation means that 68% of all price action is contained within the bands, whereas increasing the standard deviation to 2 – and hence increasing the distance from the central line – means that 95% of all price action happens within the bands.
The settings appear in the top left-hand corner of the chart, and would generally show as '20, 2' under the default settings.
Decreasing and increasing the standard deviation
Take a look at the following charts where the standard deviation has been adjusted to 1.9:
You can see that the upper and lower bands are now close together and the price breaks the bands more often, as opposed to when you increase the standard deviation to, say, 2.1 in the following chart:
You can see in the following chart a more extreme example where the Bollinger bands standard deviation settings have been set to 2.5 and the price breaks the bands less often:
By increasing the standard deviation of the Bollinger bands, you are effectively altering the levels of extremes that the price has to go in order to break through them.
Because the price will break through the Bollinger bands with a higher standard deviation less often, these higher settings potentially give you more reliable signals.
In this lesson, you have learned that …
- … Bollinger bands are an oscillator indicator, used to measure price volatility.
- … they help you identify whether a price is high or low compared to its recent moving average and predict when it might fall or rise back to that level.
- … as the price reaches the upper band, it is considered overbought and tends to fall back towards the moving average band.
- … as the price reaches the lower band, it is considered oversold and tends to rise back up towards the moving average band.
- … a big space between the upper and lower bands indicates price volatility is high, a small space indicates it is low.
- … increasing the periods used will make the Bollinger bands smoother and the price will break the bands less often. Decreasing the periods will make the bands more choppy and the price will break them more often.
- ... increasing the standard deviation will increase the distance of the bands from the central lines and the price will break the bands less often. Decreasing the standard deviation will decrease the distance of the bands to the central band and the price will break them more often.