Bands are tools that have an intense relationship with volatility, being able to help us anticipate strong movements and identify buy and sell opportunities.
The Bollinger Bands indicator is available in all versions of Vector. To add it, right-click the chart, select Add Indicator, and type Bollinger Bands.
Observing a chart over time, we'll notice intervals of high volatility and others where it seems that buyers and sellers have made a truce. However, a closer chart analysis shows us more information. Price rarely strays too far from a region, being constantly attracted to a balance zone. These zones can be identified with the application of Moving Averages.
From these observations, technical analyst John Bollinger created the Bollinger Bands. They consist of two lines, plotted above and below at a determined distance from a Moving Average.
It's a concept similar to Envelopes. With Envelopes, there are also two lines calculated from a determined distance percentage from the Moving Average. The difference introduced by Bollinger is in the usage of standard deviations.
A Bit of Statistics
A single central trend measure is not always enough to represent a set of data. Besides knowing the price where data is concentrated, it is also necessary to identify aggregation degrees, quantifying levels of data dispersion. A standard deviation is precisely a measure of data dispersion relative to its mean.
In a technical analysis context, the standard deviation distance increases or decreases, depending on volatility. Thus, the Bollinger Bands are plotted according to pre-set values of standard deviations relative to a Moving Average.
Most of the time, prices will be contained within the band's limit. Noticeably, there is a direct link between Bollinger Bands and volatility. We can easily observe this correlation during price accumulation patterns and rallies.
Interpretation Rules
There are several ways to observe and interpret bands, we’re going to cover a few of them below:
- Narrowing
When there's a balance between supply and demand, volatility decreases, producing a much narrower channel. The best analogy for this is the calm before the storm. The narrowing of the bands is a sign that a strong movement is coming.
Note the BTC/BRL chart above. The bands narrowed between June and late July 2020, remaining that way until early August, when a bullish movement began. At the same time, the bands started to widen again, reflecting the increase in volatility.
This way, the bands signal an approaching trade opportunity, but which way will the market go?
We can try to answer this question with the help of some other indicators. One technique is to look for divergences or evaluate the overbought/oversold regions with an oscillator such as IFR. However, we can’t forget the valuable information provided by volume-based indicators.
In the chart above, a descending red line shows a slight downtrend while the OBV develops an ascending trajectory (bullish divergence).
- Bollinger Band Breakouts
Two analysts might interpret the same scenario very differently under the same conditions. Let's analyze two Bollinger Bands usage rules that look antagonistic at first.
One of these rules states that a band breakout is indicative of an ongoing trend. This is a reasonable affirmation, considering that a strong trend is necessary for the price to reach the bands.
In this BTC chart, between October and December 2017, we can see prices breaking above the bands a few times in a continuous bullish movement. This is a good way to trade while following the trend, especially if you like to hold positions for a long time.
Later, however, the market reverts, even if it is just a quick break before continuing the rise. This happens because, when reaching the superior or inferior band, prices have already distanced themselves from their average and are vulnerable to corrections. Under this view, the overcoming of a band is actually an alert that suggests the liquidation of positions.
The conclusion is that the strategy used depends on the trading plan. Is your goal to maintain the position for a long time or to make short trades? Under what technical conditions will the exit happen? Where will stop orders be? These questions must be answered.
Other usage tips
Among other uses, bands are good price targets. Often, a movement that starts near one band tends to run all the way to the other. Another suggested use of the bands is to watch for signals of a trend change, such as when a candle closes outside the band, followed by another candle that closes inside.
You can find further information on this interesting tool in John Bollinger’s book, Bollinger on Bollinger Bands.
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