Bollinger Bands is a common tool used by traders in their technical analysis to measure the volatility of the asset. Traders use Bollinger Bands to identify entry and exit points
Bollinger bands were developed by the American financial analyst, author, and technical analysis contributor John Bollinger in the 1980s and were trademarked as of 2011. He is both a CFA Chartered Financial Analyst and CMT Chartered Market Technician, and now runs his own investment firm ‘Bollinger Capital Management’.
Collectively, Bollinger Bands is a set of 3 lines plotted tracking the asset’s prices across time. These 3 lines are the following:
- The middle line is a Simple Moving Average (SMA) of N periods.
- The upper band is the value of the middle line plus k times the standard deviation (SD) of the price.
- The lower band is the value of the middle line minus K times the standard deviation (SD) of the price.
Mathematically, Bollinger Bands can be represented with the formula
BB = SMA ± k x SD
K = Constant
In the image above, The inner line represents a moving average for a specific period and is denoted as a midline. It is essentially the average price of a cryptocurrency over a specific number of days. Bollinger bands typically use a 20-day moving average, which is the average price of a cryptocurrency over the last 20 days. The outer lines form the range or ‘bands’ in which the price is expected to move up or down, and are typically two standard deviations (standard deviation measures the amount of variation/deviation from the mean) from the midline. The width of the band denotes the volatility of the market at that particular time. This way, High and Low volatility periods can be easily spotted with the help of Bollinger Bands.
In some conditions, Bollinger Bands also help you identify the overbought and oversold areas as these areas are directly related to the Moving Average. When the price touches or moves outside of the band on either end, it is considered a ‘tag’ and not a trading signal. When the upper band has been breached, it usually represents that the cryptocurrency has been overbought, and will correct. This is usually a good time to sell. When the lower band has been breached, it typically signals that the cryptocurrency has been oversold, which is a good entry point to buy. When new highs are reached outside the band, immediately followed by daily highs inside the band, it typically signals a trend reversal. The same is true on the opposite end. Adding to this, Bollinger bands can also detect a trend continuation pattern if the price surpasses the upper band or falls below the lower band, then we have a strong signal of continuation of the current trend.
HOW TO USE BOLLINGER BANDS IN TRADING?
- Bollinger Bounce – Bollinger bounce is the most simple strategy to trade cryptocurrencies using Bollinger bands. Considering that the lower band provides oversold levels and the upper band overbought ones, just buy when the market is near the lower band, or below it, and sell when the market price is near or above the upper bands. If the Bollinger bands are almost flat, then it’s a good time to trade the Bollinger bounce strategy.
- Bollinger Squeeze – Bollinger squeeze provides a way to detect a new pattern starting from a point. One must look for an extended low volatility period, with narrowing bands, and wait for a candle closing above or below the bands as they start to expand. Once you identify this pattern, just trade in the direction of the breakout.
Bollinger bands are more useful when used alone and should be used in conjunction with other indicators for trend confirmation. Relative Strength Index (RSI) and Volume to name a few, are two common indicators that are used with Bollinger Bands when analyzing the candlesticks. It is always advisable to use multiple technical indicators to come to a trading decision as a single indicator can possibly be telling half the story. Multiple indicators bring more clarity and confidence in the picture.