Bollinger Bands is an oscillating indicator used to measure market volatility.
It allows for the evaluation of high or low prices compared to the moving average over a specific time period. Moreover, it helps predict an increase or decrease to its level. This information can guide decisions about whether to sell or buy an asset.
Bollinger Bands Indicate Overbought and Oversold Markets
Bollinger Bands consist of three main lines (or bands).
The center band corresponds to the simple moving average price. The lower and upper bands, on the other hand, show levels at which the price can be considered low or high relative to the moving average over the last time interval.
In the image below, Bollinger Bands are shown on the price chart. Most price movements often lie within the bands’ limits. This aids in their use to predict market reversals.
Overbought
When the price reaches the upper band, the asset will trade at a high price and will be considered overbought. Therefore, at this moment, you can sell it and wait for the price to fall in the future to the central band, which represents the moving average.
Oversold
When the price reaches the lower band, the asset will trade at a low price and will be considered oversold. Therefore, at this moment, you can buy it and wait for the price to rise in the future to the central band, which represents the moving average.
However, you must still be cautious, as reaching the lower or upper band once does not necessarily indicate a reversal. You will need more data (e.g., candlestick patterns, other indicators) to confirm the reversal before opening a trade.
Distance Between Bands
The distance between the lower and upper bands can also determine market volatility using Bollinger Bands. A small distance indicates low volatility, while a large distance signifies high volatility.
In the chart above, the blue zone shows bands that are close together, indicating low volatility. The green zone follows, where the price became more volatile and started to rise, and the distance between the bands also grows.
Changing Settings
Bollinger Bands have two parameters that can modify the behavior of this indicator. These parameters are standard deviation and number of periods.
Changing the Period
The bands have a standard value of 20 candles or 20 periods. The period relates to the time interval, and the indicator is calculated based on price movements over this interval.
A smaller number of periods
The indicator will respond more quickly to changes if a smaller number of periods is used. As a result, the lower and upper bands become less smooth. The price will more frequently breach the bands and allow trading. However, the number of false signals will also increase.
In the chart below, the value equals ten, resulting in frequent breaches of the lower and upper bands by price.
Higher Number of Periods
The indicator will not respond as quickly to changes if many periods are used. As a result, the lower and upper bands become smoother.
The price will not breach the lower and upper bands as often, and will give fewer signals, but any signal will be more reliable.
In the picture below, the bands with a period value of 40 are shown, which is twice the standard. If you compare this to the previous chart, you can see that the distance to the outer bands is much larger, and the price breaches them much less often.
Changing Standard Deviation
By default, the standard deviation value of Bollinger Bands is 2.
The standard deviation indicates how fully the graphical data of the normal distribution of the moving average will be taken into account in the Bollinger Bands indicator.
If you increase the standard deviation, you can extend the distance from the bands to the centerline. As a result, more price movements will be contained between them.
A value of 1 here will indicate that 68 percent of price movements are contained within the bands. But increasing the deviation to 2 will extend the distance from the central line and change the indicator to 95 percent of total price movements.
The parameters are located in the top left corner of the chart and are most often shown as 20, 2 under the standard settings.
Increasing and Decreasing Standard Deviation
In the chart below, the standard deviation is changed to 1.9.
The lower and upper bands are now closer, and the price breaches them more often. But when the standard deviation is increased (for example, to 2.1), the opposite will occur.
The chart below shows another case where the standard deviation equals 2.5, and the price does not breach the bands as often.
If you increase the standard deviation of the Bollinger Bands, you can successfully change the level of extremity that the price must reach in order to breach the bands.
The price will breach the bands less often at higher standard deviation settings. However, such settings can provide more reliable signals.