John Bollinger was a financial analyst who became a highly successful market technical analyst sometime in the late 80s.
Thanks to him, over 70% of professional financial traders in the crypto, stocks, bonds, and forex markets have a simple and effective way to identify trade opportunities.
He developed the use of 3 bands within a chart to identify trends and imminent price reversals.
What Are Bollinger Bands?
These 3 bands consist of the upper band, the middle band, and the lower band. The middle band is just a simple moving average of currency prices while the upper and lower bands measure the standard deviation that defines the currency pair’s pricing channel and measure price volatility.
Understanding Standard Deviation and Bollinger Bands:
The main function of standard deviation in mathematics is to measure and describe dispersal patterns of data sets. As a trader, you do not necessarily have to be proficient in mathematics or the calculation of standard deviation.
Instead, you have to understand what the dispersal rates mean when compared to the moving average. This understanding is what will guide you in identifying buy and sell opportunities.
The area that falls between the middle band and either the upper or the lower band is referred to as a range or channel. The range falling above the moving average is the buy channel whereas the area falling below the middle band is the selling channel.
However, this is because spot rates in the buy channel suggest an upward price momentum while spot rates in the selling channel suggest a downward price momentum.
Furthermore, when the upper band starts to move closer to the middle band, it indicates a convergence of the spot rate and the average rate – thus, suggesting an impending price reversal.
The same is true with the lower band approaching the moving average. When spot rates go beyond the lower or upper bands, this is referred to as “breaking the band”.
Volatility And Reversals:
Furthermore, crypto traders should know that rate reversals are usually preceded by high volatility. Bollinger bands are the perfect technical tools for identifying increasing volatility as they are characterized by a widening of the bands while a narrowing of the bands indicates decreasing volatility.
Extreme volatility is characterized by the “breaking of bands” which of course, is the Bollinger bands’ strongest indication of imminent trend reversals.
When spot rates break through the upper band (buy channel) we have overbought market conditions and when they break below the lower band (sell channel) we have over-sold conditions. Both of these are trend reversal signals.
Bollinger Parameter Settings:
Most price charts use a default setting of (20, 2) for the position of lower and upper bands or a number of deviations from the moving average.
This means that the past 20 trade reporting periods for the asset price information are used for calculating the moving average. In addition, the buy and sell bands are set at a distance of 2 standard deviation units away from the middle band.
Traders are, however, free to use their own customized setting even though the (20, 2) setting is the most commonly used and considered optimal.
When changing these settings, the trader has to ensure that all exchange rate fluctuations are kept within the bands.
This makes it easier to differentiate between typical price fluctuations and possible price reversal signals.