Explained: What Are Bollinger Bands & How to Use It For Crypto Trading?
Cryptocurrency traders are interested in efficient technical analysis indicators that would help them anticipate the next price moves and accurately determine current trends. There is a belief that complex indicators that cover the chart with multiple lines, histograms, and elements can provide better signals. However, this is not true. Often times, the traditional method is more effective and straightforward. One of the best technical indicators that have been used for decades and still work well is Bollinger Bands.
Bollinger Bands refer to a technical indicator made up of three lines that form a channel comprising the price action. The middle line is a simple moving average (SMA), while the upper and lower lines derive from the SMA and move based on price volatility. Traders use Bollinger bands to determine the current trend, measure volatility, and anticipate potential trend reversals.
Table of Contents
- What Are Bollinger Bands?
- Understanding The Concept of Bollinger Bounce and Bollinger Squeeze
- Why Is Bollinger Bands Important in Crypto Trading?
- How to Use Bollinger Bands in Crypto Trading?
- Bollinger Band Variations
- What to Consider When Crypto Trading with Bollinger Bands?
- Closing Thoughts
What Are Bollinger Bands?
Bollinger Bands are among the most popular technical indicators out there. Mainly because of its precision as volatility indicators, which are used to determine how high or low is the price relative to previous closes.
The indicator was developed by John Bollinger in the 1980s for analyzing stocks and has remained among the most preferred price analysis tools since then. Though Bollinger bands are popular in the traditional market, the crypto market is no exception and traders do embrace this indicator. That is especially when volatility indicators are imperative in cryptocurrency trading.
The Bollinger Bands are formed from three bands:
- The Middle band— Simple Moving Average (SMA).
- The Upper band— is the SMA plus two standard deviations to define a measure of variation from the middle band that let the upper and lower bands expand and contract accordingly to the price volatility.
- The Lower band is the SMA minus two standard deviations.
As mentioned, Bollinger Bands are made up of two lines plotted above and below a simple moving average. By default, the indicator comes with period 20 for the Simple Moving Average (SMA) and two standard deviations for each of the upper and lower lines. The distance between the lateral bands depends on the standard deviations. Thus, the bands narrow when the market is calm and widen when the volatility increases.
That is what the bands look like on the chart:
However, the parameters can changable manually depending on the trader’s needs. For example, you can set an SMA 15 with two and a half standard deviations for the bands.
In case you’re not familiar with standard deviations, the concept refers to how spread out numbers is relative to a value. For example, if the upper and lower bands are set at one standard deviation, this suggests about 68% of recent price moves are contained within these bands.
On the contrary, if the two bands are set at two standard deviations, this means about 95% of the price moves within a tracked period are contained within the channel formed by the bands. Here is an image showing how much can be covered by different standard deviation values:By M. W. Toews – Own work, based (in concept) on figure by Jeremy Kemp, on 2005-02-09, CC BY 2.5,
Besides measuring the price volatility, Bollinger Bands can also help traders determine the overbought and oversold levels, thus acting like a momentum indicator.
Since it has an SMA embedded in it, Bollinger Bands can perform well as a trend-following indicator. Even though this indicator is universal, it still makes sense to combine it with other technical tools for better signals.
Characteristics of Bollinger Bands
To critically identify and to utilize Bollinger bands critically, here are the main characteristics:
- This indicator is used to measure the volatility of a price, though it can also effectively determine the trend as well as the overbought and the oversold levels.
- Bollinger Bands is an indicator consists of three lines; an SMA 20 and an upper and lower line, each set with two standard deviations by default.
- The bands automatically expand when volatility increases and narrow when the market calms down.
- The price tends to return to the middle of the bands. Thus, every time it touches one of the bands, you can expect it to bounce to the opposite side. Hence, that makes Bollinger Bands a good indicator for swing traders.
- If the bands are very close to each other for a while, a breakout may happen in either direction.
Understanding The Concept of Bollinger Bounce and Bollinger Squeeze
Two of the most critical trading systems provided by Bollinger Bands are Bollinger Bounce and Bollinger Squeeze. The former is a trend reversal strategy whose main idea is that the price tends to bounce back to the middle whenever it touches one of the bands. Thus, when the price touches the Bollinger Bands’ upper line, traders would usually go short, and vice versa.
To put it in context, you can think about the bands as dynamic support and resistance levels. The relevance of the bands increases with larger timeframes. Hence, this strategy is suitable for swing traders who use to leave their positions open overnight.
Bollinger Bounce works better during sideways trends when the volatility is relatively low. Beginners tend to ignore such market conditions, but this strategy can be lucrative, specifically when the trend is unclear. If the bands are expanding, then you should give up trading the Bollinger Bounce strategy because the price is forming a new trend.
During low volatility, you can use the other strategy – Bollinger Squeeze. When the bands squeeze together, you should be ready for a breakout. If the price breaks above the top bands, traders are opening long positions as the price is expected to continue to move up. If the candle breaks out below the bottom band, traders go short because the price will continue to go down.
While there are many trading systems based on Bollinger Bands, these two strategies are the most common ones.
Why Is Bollinger Bands Important in Crypto Trading?
As you may know, one of the main characteristics of cryptocurrencies is volatility. Digital currencies are relatively new compared to traditional assets, which is why they tend to react much quicker and steeper to market events and large transactions. That is why a technical indicator that considers volatility in the first place should help crypto traders better analyze the price action and improve decision-making.
Bitcoin, the largest and oldest cryptocurrency out there, has demonstrated extreme volatility that is relatively unusual for traditional digital assets. It can behave like that both on larger timeframes and inside every trading session. For example, in 2020, it’s price tumbled below $5,000 during the March nosedive. But reaches a spectacular all-time-high over $41,000 in the early of January 2021. That shows a whopping 156.522% difference in price.
Trading extremely volatile assets are not easy, especially for beginners. So, to mitigate risks, using indicators like Bollinger Bands can help you determine entry and exit points more accurately.
How to Use Bollinger Bands in Crypto Trading?
Using Bollinger Bands in cryptocurrency trading is no different from using it when trading traditional assets, such as forex pairs or company shares.
Nevertheless, you should expect more volatility from digital assets, trading opportunities, and signals from this particular indicator.
Here is how you should set the Bollinger Bands depending on the trading style:
- Short-term (Day Trading) – Simple Moving Average with period 10 and bands at 1.5 standard deviations;
- Medium-term (Swing Trading) – Set SMA with period 20 and bands at 2 standard deviations. In fact, you should not change anything because these are the parameters by default.
- Long-term (Position Trading) – Use a 50-day SMA and bands at 2.5 standard deviations.
As a rule, when the bands narrowed during low volatility, you should be ready for a breakout in either direction. Still, it would be best to wait for a confirmation that the breakout ends up with a new trend. That is to avoid the possibility of an isolated spike or slump. After all, this is the main idea behind the Bollinger Squeeze strategy, which works well with digital currencies.
Besides Bollinger Bounce and Squeeze, cryptocurrency traders can also use Bollinger Bands to trade so-called W-bottoms and M-tops, which are patterns that show up on the candlestick charts. They are very similar to double bottoms and double tops.
For a valid W-bottom, we should check whether the first low, which usually shows up beneath the lower band of the indicator, is lower than the second low, which is always inside the bands. Once the cryptocurrency bounces back from the second low, traders open long positions.
The M-top pattern is the opposite of the W-bottom. The pattern forms when a rally ends up with a pullback followed by another test of the resistance established by the previous high. If the price fails to break above the resistance, then a double top-like pattern shows up. The main condition is that the first high should be outside of the bands while the second high maintains inside the bands. When this pattern appears on the chart, traders go short.
Day Trading Bollinger Bands (Short-Term)
Since many retail cryptocurrency traders prefer day trading, here is how Bollinger Bands is applicable in uptrends and downtrends:
The indicator can show you the rally’s strength and when it might reverse or lose its strength. If the uptrend is strong enough, it tends to touch the upper band regularly. The uptrend that reaches the top band suggests that the cryptocurrency continues to grow, and traders may continue with the bullish sentiment.
At some point, the price might retreat to a certain level. If it pulls back but maintains above the SMA and then rebounds towards the upper band again, it indicates plenty of strength. The point is that the price action should better not touch the lower band during a rally. If it does, then it is a sign that the uptrend is losing strength and may reverse.
Most day traders aim to benefit from strong upward trends before the first signs of a reversal. If the cryptocurrency fails to touch a new high, traders will close the position to prevent losses.
Hence, Bollinger Bands are a great indicator to monitor an uptrend’s state to measure its strength or weakness and anticipate a possible reversal.
In downtrends, traders use Bollinger Bands to measure a bearish move’s strength and when it might reverse to an uptrend. If the downtrend is strong, the price will move very close to the lower band. Naturally, it suggests that selling activity maintains high.
Once the price fails to touch new lows and move along the lower bands, it is a strong signal that the bearish trend is losing momentum. Under these circumstances, short-sellers would exit their positions.
In a bearish market, traders would interpret it as the strongest signal of an upcoming reversal if the price reaches the upper band or breaks above it. Many traders don’t prefer to trade during downtrends, as most cryptocurrency aims to expand their market valuations in the long-run. So, they’ll feel like trading against the general trend. They choose to monitor bearish moves only to search for opportunities to buy the dip.
Bollinger Band Variations
Cryptocurrency traders can also use Bollinger Band variations, such as Bollinger Bands Width and Bollinger Bands %B (percent bandwidth). We will focus on the latter, as it is the most popular variation and comprises the features of the former one as well.
The Bollinger Band %B is an indicator that quantifies where the crypto price is relative to the bands. Thus:
- When %B is above 1, it suggests that the price is above the upper band;
- When %B equals 1, it means that price is at the upper band;
- When %B is above 0.50, it suggests that the price is above the middle band;
- When %B is below 0.50, it means that the price is below the middle band;
- When %B is equal to zero, it shows that price is at the lower band;
- If %B is below zero, it means that the price is below the lower band.
The %B resembles an oscillator and is shown below the main chart. It helps traders identify trends and signals.
What to Consider When Crypto Trading with Bollinger Bands?
Bollinger Bands are among the most popular technical indicators for excellent reasons. But it cannot predict a cryptocurrency price as with any other indicators. The bands react to the price movement in real-time, but the indicator cannot anticipate what comes next. You can regard it as a lagging indicator, especially when it is based on a simple moving average, which considers the last few periods’ average prices. Still, anticipating the next price moves is your job, and Bollinger Bands can provide relevant hints.
Precautions To Take Note
It’s best to understand when you should use the Bollinger band. That way traders can mitigate the risks of misinterpretation when analyzing the chart.
Know How to Determine Bollinger Squeeze or Bounce
When the squeeze occurs, the sigma band represents a sign of inversion. But when the trend is happening, the sigma band will be a positive signal when touched. Ultimately, you need to critically decipher the Bollinger bands’ shape by including different signals like the moving averages and candlesticks. The key to achieving high accuracy when accessing the Bollinger Band is to consider the other indicators too.
Look at Multiple Timeframes
Focusing only on a specific timeframe limits your capability to analyze the market trend accurately. As a rule of thumb, the longer the time frame, the more reliable the signals are. That said, if you’re short-term trading focusing only on a small-hourly chart, the charts might possess false moves and noises. For example, suppose you set only an hour time frame. In that case, even if there’s a downtrend when analyzed on a daily or weekly basis, it’ll not be accurately projected when there’s a significant uptrend when being assessed in a holistic picture.
Whether you’re a novice crypto trader or otherwise, Bollinger bands proves to be a reliable and useful indicator in chart analysis for decades. When this indicator is used correctly, it helps identify the bad and positive entries in advance. Try trading with a normal setting value if you’re a beginner and make changes accordingly to suit your trading style.
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