Bollinger Bands: Definition and Interpretation for Crypto Trading
Developed by John Bollinger in the 1980s, Bollinger Bands are a versatile and widely used technical analysis tool. They help traders identify trends, assess market volatility, and determine potential entry and exit points. In this article, we'll explore the intricacies of Bollinger Bands and how they can be applied to crypto trading.
A short history of Bollinger bands
John Bollinger, a seasoned market analyst and trader, developed Bollinger Bands in the early 1980s as a way to improve upon existing volatility-based trading tools. At the time, volatility indicators such as moving average envelopes and percentage bands were already being used by traders. However, Bollinger noticed that these tools were unable to adapt to changing market conditions effectively.
To address this issue, Bollinger introduced a new approach that incorporated standard deviation, a statistical measure of price dispersion, to create dynamic bands that expand and contract based on market volatility. The result was Bollinger Bands, a set of three lines consisting of a simple moving average (usually 20 periods) and two bands – one above and one below the moving average – each set at a specific standard deviation (commonly set at 2).
What are Bollinger Bands and how do they work?
Bollinger bands consist of a upper and lower band that are placed 2 standard deviations away from a simple moving average – the middle band. The space between the two bands is called the Bollinger bandwidth.
Upper Band
The upper band represents the highest price level the asset is expected to reach within the specified time frame. It is calculated by adding a predetermined number of standard deviations to the middle band.
Middle Band
The middle band, often referred to as the "basis" or "central line," is typically a simple moving average (SMA) of the asset's price over a specific period. This serves as the foundation of the Bollinger Bands.
Lower Band
The lower band signifies the lowest price level the asset is anticipated to reach during the specified time frame. It is calculated by subtracting a predetermined number of standard deviations from the middle band.
The space between the Bollinger bands increases whenever there is strong price movement.
How to calculate the Bollinger bands?
The calculation for Bollinger bands is fairly simple. The first step is to calculate a simple moving average of the security’s price over a certain period of time. The most common time periods are 20 periods, 50 periods, and 200 periods. Once you have the moving average, you can calculate the upper Bollinger band by adding 2 standard deviations of the close price during the calculated number of periods to the moving average. To calculate the lower Bollinger band, you would simply subtract 2 standard deviations of the close price from the moving average.
Formula to calculate Bollinger bands
Upper Bollinger band: X-period SMA + (2 x Standard Deviation of the close price over X periods)
Middle Bollinger band: X-period SMA
Lower Bollinger band: X-period SMA – (2 x Standard Deviation of the close price over X periods)
NB: The Standard deviation is the square root of the variance. The variance is the mean of the squared difference of each value to the mean.
The Bollinger bandwidth can be used to gauge how far prices have moved away from the moving average. Bollinger bandwidth is simply the difference between the upper Bollinger band and the lower Bollinger band. The Bollinger bandwidth expands when volatility increases and contracts when volatility decreases.
An important thing to note about Bollinger bands is that they are based on historical data and do not predict future price movements. Bollinger bands can only be used to help you make informed trading decisions.
Using Bollinger Bands in crypto trading
Bollinger bands are one of the most popular technical analysis indicators in crypto trading and can be used to spot overbought and oversold signals, trends, high and low volatility and ultimately entry and exit signals.
Overbought and oversold signals
Bollinger bands can be used for a variety of purposes, but they are most commonly used to identify overbought and oversold conditions in the market. When the market is overbought, the price reaches the upper band. It means that prices have risen too high too quickly and may be due for a correction. On the other hand, when the market is oversold and the price hits the bottom band, it means that prices have fallen too low too quickly and may be due for a rebound.
Trend identification
Bollinger Bands are effective at identifying price trends. When the bands move in the same direction, either upwards or downwards, it suggests that a trend is in progress. Conversely, when the bands move sideways or converge, it may indicate a lack of trend or a potential trend reversal.
Volatility assessment
As mentioned earlier, the width of the Bollinger Bands reflects market volatility. Wider bands suggest greater volatility, while narrower bands indicate less volatility. This can help traders gauge the risk involved in a trade and adjust their position sizes accordingly.
Entry and exit signals
Bollinger Bands can provide valuable entry and exit signals for traders. When the price crosses the upper or lower band, it may signal a potential reversal or continuation of the trend. Additionally, traders may use the middle band as a reference point for their stop-loss and take-profit orders.
Bollinger bands trading strategies
There are two common trading strategies to be applied to the Bollinger bands technical analysis indicator, the Bollinger bounce in which the trader expect the price of the cryptocurrency to “bounce” from one band to another, and the breakout from a squeeze.
The Bollinger bounce
The Bollinger Bounce is a trading strategy based on the idea that prices tend to "bounce" off the upper and lower bands. When the price touches the upper band, traders may consider it overbought and expect a reversal to the downside. Conversely, when the price touches the lower band, it could be considered oversold, and traders may anticipate a bounce back upwards. To increase the effectiveness of this strategy, traders should look for confirmation from other technical indicators or price patterns before entering a trade.
The Bollinger band squeeze and price breakouts
The Bollinger Squeeze occurs when the bands contract, indicating low market volatility. Traders use this strategy to identify potential breakouts, as periods of low volatility are often followed by significant price movements. When the bands start to widen after a period of contraction, it signals that a breakout may be imminent. Traders can then monitor the direction of the breakout and position themselves accordingly.
This Bollinger Bands squeeze was immediately followed by a bearish breakout.
What other technical analysis indicators can be used with Bollinger Bands?
Bollinger bands can be used in conjunction with other technical indicators. Some common indicators that are used with Bollinger bands include the Moving Average Convergence Divergence (MACD) indicator and the Relative Strength Index (RSI).
Combining Bollinger bands and RSI for better trading signals
For instance, if the price closes above the upper Bollinger Band and the RSI is above 70, it is a strong overbought signal that can indicate a trend reversion. The market might enter a bearish phase. On the other hand, if the price closes below the lower Bollinger Band and the RSI is below 30, it is a strong oversold signal that can indicate a possible bullish trend incoming.
Combining Bollinger bands and MACD for better trading signals
As for the MACD, it could be used to confirm the formation of a trend after a Bollinger band squeeze. A sudden touch of the price of the upper used accordingly with an MACD cross signal can be used to enter a long position more confidently. Conversely, a price touch of the lower Bollinger band with a bearish MACD cross can be used to enter a short position.
Tips for successful crypto trading with Bollinger bands
- Combine Bollinger Bands with other technical indicators: Bollinger Bands are most effective when used in conjunction with other technical analysis tools, such as moving averages, RSI, or MACD, to confirm trading signals and reduce the likelihood of false signals.
- Adjust the settings to suit your trading style: The default settings for Bollinger Bands (20-period SMA and 2 standard deviations) may not always be suitable for your specific trading strategy or the crypto asset you are trading. Experiment with different settings to find the optimal combination for your needs.
- Be cautious during periods of extreme volatility: Although Bollinger Bands are designed to measure volatility, extreme price movements can sometimes result in false signals. Exercise caution and use additional confirmation from other indicators during periods of high volatility.
- Practice proper risk management: As with any trading strategy, it's essential to manage your risk by setting appropriate stop-loss and take-profit levels, as well as maintaining a diversified portfolio.
Conclusion on Bollinger bands
Bollinger Bands are a powerful tool for crypto traders, providing valuable insights into price trends, volatility, and potential entry and exit points. By understanding their components and incorporating them into various trading strategies, traders can improve their decision-making process and increase their chances of success in the highly competitive world of crypto trading.
Frequently asked questions on Bollinger bands
1. What are Bollinger Bands?
Bollinger Bands are a technical analysis tool developed by John Bollinger in the 1980s. They consist of three lines (upper, middle, and lower bands) plotted on a price chart to help traders identify trends, assess market volatility, and determine potential entry and exit points.
2. How do I use Bollinger Bands in crypto trading?
Bollinger Bands can be used to identify trends, assess market volatility, and generate entry and exit signals. By combining Bollinger Bands with other technical indicators and using them in various trading strategies, traders can improve their decision-making process.
3. What is the Bollinger Bounce trading strategy?
The Bollinger Bounce is a trading strategy based on the idea that prices tend to bounce off the upper and lower bands. Traders use this strategy to identify potential reversals and continuation of trends.
4. What is the Bollinger Squeeze?
The Bollinger Squeeze occurs when the bands contract, indicating low market volatility. Traders use this strategy to identify potential breakouts, as periods of low volatility are often followed by significant price movements.
5. Can Bollinger Bands be used for all types of cryptocurrencies?
Yes, Bollinger Bands can be applied to any cryptocurrency or financial asset with price data. However, it is essential to adjust the settings and use additional technical indicators to suit the specific crypto asset and your trading style.