Bollinger Bands are a powerful technical analysis indicator created by John Bollinger in the 1980s. Bands and channels provide relative definition of high and low which can be used to identify trends and measure volatility.
John Bollinger wasn’t the first person who used bands or channels as a trading tool – having an envelope around the price was a common practice since the invention of a famous trading tool – Donchian channels.
Donchian channels. The upper band is the highest high of the last 20 candles, lower band is the lowest low of the last 20 candles. A buy signal is generated when price breaks up the upper channel, and a sell signal is generated when price breaks below the lower channel.
Donchian channels are static – an indicator doesn’t account for price movements in between highs or lows; on the other hand, Bollinger Bands are dynamic. The band is changed on each new candle thus it is much more accurate.
So what are Bollinger Bands?
Bollinger Bands as any other bands are based on some measure of central tendency – in this case on 20-period simple moving average. The upper and lower band are usually built using a measurement of market volatility. For example, if an asset has an average of 10% volatility then you can simply use a moving average shifted up and down by 10% to build the bands. But John Bollinger concluded that volatility is not static but dynamic – thus this static approach is inaccurate.
Bollinger Bands use standard deviation to build the bands. It’s very common statistical measure which in this case helps to build bands accounting for dynamic price volatility. As a result 90% of price movement on any timeframe is contained within the bands.
These bands provide a relative definition of high and low. By definition, price is high at the upper band and low at the lower band. Does it mean that trader should always buy once price reaches lower band and sell when it hits an upper band? Not exactly, even though a touch of the band might indicate a weak short-term reversal.
EOS/BTC daily chart – a good example why a touch of upper band doesn’t mean trend reversal.
In this EOS/BTC example each touch of an upper band resulted in a short-term retrace but intermediate-term trend continued. On the 7th touch of an upper band M-top was formed and intermediate-term trend had changed.
Bollinger Bands are used for identification of W-bottoms, M-tops and Squeezes. W-bottoms and M-tops are self-explanatory: these are patterns which indicate a trend reversal. The Squeeze is much more interesting, but before exploring these terms we need to add two more tools to our arsenal: %b and BandWidth. Both indicators are derived directly from Bollinger Bands.
The first indicator, %b, tells us where we are in relation to the Bollinger Bands. It is the key to the development of trading systems via linking of price and indicator action. Here’s the formula:
%b = (Last price – lower BB) / (upper BB – lower BB)
This resolves to 1.0 when price reaches an upper bound, 0.5 at the middle band and 0.0 at the lower band. %b is not bounded hence it will exceed 1.0 when price is above the upper band and 0.0 when price is below the lower band.
It allows all sorts of relative comparisons. For example, if you wanted to build a trading system in which you enter on the increasing momentum after successful retest of the lows you could write an algorithm:
If %b of the first low is below 0 and %b of the second low is above 0 then buy at the next up day if the volume is above average.
LTC/USD chart. Example of following algorithm described above.
BandWidth is calculated subtracting a lower band from an upper band and normalizing it with the middle band (which in our case is 20-period simple moving average).
BandWidth = (upper BB – lower BB) / middle BB
It is used for identifying The Squeeze – the situation where volatility has fallen so much that its lowness has become a forecast of increased volatility in the future.
High volatility begets low volatility and vice versa.
Most of the trends are born after a long and exhausting ranging with a low volatility. A huge expansion in the BandWidth after such a range usually indicates a start of sustainable uptrend.
DOGE/BTC. Low volatility ranges are usually followed by rapid volatility expansions and mark the beginning of the new trend.
Both indicators compliment Bollinger Bands and help the trader not only to understand the current state of the market, but also to compare the current BBands to the previous ones. This DOGE/BTC example illustrates that both squeezes occurred roughly at the same width of the BBands.
Identification of Patterns
It is well known that price forms dozens of different technical patterns: double bottoms, double tops, flags, pennants, you name it. All these patterns have a certain chance of unfolding in certain way which for us translates to a trading edge.
Bollinger Bands helps in pattern recognition by providing definitions of low and high, volatile and calm. These definitions can be easily compared one with another using %b and BandWidth. As the pattern continues, the bands evolve and provide a flexible framework for defining support and resistance as opposed to hard drawn trendline analysis.
Price rarely goes from a bearish phase to bullish phase in an abrupt manner. The transition usually forms a structure with several breakouts and retests of prior resistances. These structures usually take form of some common chart pattern, for example an inverse head & shoulders or double bottom. Ms and Ws are the most frequent trend reversal patterns and Bollinger Bands provide a very easy way of identifying them.
It’s important to note that not all reversal patterns are Ms or Ws. There is always a chance that W pattern will lead not to immediate trend reversal but to the third touch of the lows and formation of an inverse head & shoulders, but these patterns are rarer so we stick to Ms and Ws. Also, spike tops and V bottoms, which change direction of the trend in one movement, do occur, but they are usually driven by fundamental events. And last but not least, some Ms and Ws don’t mark the beginning of the new trend but the end of the current one – price might enter accumulation zone which can be confirmed later using the BB Squeeze.
Definition of Ws and Ms
The Ideal W
An ideal example of W involves an initial decline followed by a recovery rally and then a secondary decline followed by the initiation of an uptrend. The initial decline must break down the lower band (%b is below 0) and the secondary decline must remain in the bands (%b is above 0). Volume is higher on the first decline.
Remember: it’s not important whether the second decline makes a lower low or not on an absolute basis. All that matters is that the second decline is higher relative to the %b of the first low, not the absolute price.
An example of ideal W-bottom on WABI/BTC chart
Why do we define the W bottom this way? Why should volume of the first sell-off be greater than the volume of the second decline? One must think in terms of momentum (this is why momentum indicators are so often used in combination with BBands). Typically a decline which forms at least an intermediate-term bottom should end in an accelerated move with a lot of momentum which exhausts the sellers. If the second decline has the same or even higher volume, chances are that it will continue to fall.
WABI/BTC with addition of RSI – a common momentum indicator.
In this WABI/BTC example the first sell-off ended with a climax – sellers had a lot of momentum and RSI reached oversold zone. The second decline on the other hand stopped above the oversold zone and showed us that the W pattern is valid.
Underlying Difference Between Ws and Ms
Bottom formations are usually much cleaner and easier to see. The main difference lays in psychology: bottoms are formed in the environment of pain and fear; tops are formed based on hope and euphoria. As a result, bottoms are sharp and fast meanwhile tops are either more prolonged or very rapid (in case of the unsustainable growth) forming a spike instead of M. Secondly, people usually don’t act at tops in the same urgent manner they do at bottoms.
Identifying The Top
It seems obvious that to define M you need to inverse the definition of W. But that’s not the case. Ms are usually much more complex and harder to identify. It is rare to see a clear M formation resulting in the change of the trend – usually it ends with a combination of at least two Ms known as Head and Shoulders.
The classic pattern would be the left shoulder breaking above higher band, a head which makes a higher high relative to the price but stays between the bands (or usually touches it) and the right shoulder which is lower both relative to the price and %b of head.
BTC/USD chart. Example of identifying the head & shoulders pattern using Bollinger Bands.
The head and shoulders pattern is broken into two M-tops: left shoulder + head and head + right shoulder. It’s also common to see Ms and Ws form in between the peaks. In the case of this BTC/USD chart W bottom between the head and the right shoulder was invalid because the second decline was lower than the first one relative to the %b (stronger momentum on the second leg down).
As you can see, M-tops are tricky business and thus they don’t create such a strong reversal signal as Ws do. The only thing you really need to keep in mind is relativity: whenever a high is formed outside of the higher band and the second high is formed below the higher band it’s at least suspicious and worth investigating. It’s very similar to oscillator/volume divergences. As a trader it can pay to consider a top being formed during these events.
The Squeeze is the most anticipated price action by traders who use Bollinger Bands. The main rule of volatility works like a charm: high volatility begets low volatility and vice versa.
It’s known that (most) traders make money not in chop but in trending markets and squeezes create the first signals of the incoming volatile move.
There are several definitions of the squeeze. The simplest one is that a squeeze is formed when BandWidth drops to a 6-month low. Obviously it’s just a general rule and each market might behave differently.
The general misconception is that squeezes always result in an upward movement – that’s not the case! Squeezes just indicate that there is a prolonged period of low volatility and that the next volatile move is coming. It doesn’t provide any information on the direction of the move whatsoever.
DASH/BTC chart. Example of downwards movement after the squeeze
Here is how a typical squeeze unfolds:
- Consolidation begins
- Trade range drastically reduces
- Averages flatten out
- BBands begin to tighten around the price structure
Then, based on the other indicators we might guess a more probable direction of an upcoming move. Everything comes in handy: oscillator divergences, volume, Ichimoku Cloud or any other tool you are comfortable using. Also don’t forget about news – they are usually a very strong catalyst which can decide which way market is going.
But beware, it’s common to see a fake out in the wrong direction before the real trend begins. This move is called a head fake.
AMP/BTC chart. Example of the head fake
To deal with it you need to use other trading tools mentioned above. In this case of AMP/BTC chart we could see a very clear W bottom with an oscillator divergence. The best idea is not to enter the position in full size based only on the squeeze – you might lose your confidence right at the bottom of the head fake and get shaken out. Increase your position gradually on the confirmation of an uptrend.
Well, that’s a lot to remember! There are a tons of nuances in trading using Bollinger Bands so I decided to create a list containing all the important information you might want to refer to later.
- Bands provide relative definition of high and low. By definition price is high at the upper band and low at the lower band
- Price rarely goes from bearish to bullish or vice versa – it usually forms some kind of reversal pattern
- The most common reversal patterns are W-bottoms and M-tops
- An ideal W-bottom consists of the first decline breaking below the lower bound and the second decline staying in between the bands. Volume of the second decline should be much lower. Bonus points if the first decline had a great momentum
- The most common bearish reversal pattern is head & shoulders which is a combination of two M-tops
- If the first high broke out of higher band and the second high is in between the bands it’s not a confirmed reversal but suspicious at the very least
- High volatility begets low volatility and vice versa
- The Squeeze doesn’t provide any information on the direction of an upcoming move
- Be aware of head fakes. Don’t forget to use other indicators entering the trade based on a squeeze
At last, if you have any questions, John Bollinger, the man himself, is very active on twitter and answers any questions related to his indicator. Also check out his website, it contains A LOT of useful information.
Thank you for reading and good luck in the markets!