Bollinger Bands is a technical analysis tool, designed by mathematician and engineer John Bollinger, primarily used to measure a financial asset’s price volatility to predict entry and exit points in the market.
In this article, we will explain Bollinger Bands and how they can be used to calculate the future value of cryptocurrencies. Additionally, we will detail how they can be applied to different crypto trading strategies and discuss their benefits and risks.
What are Bollinger Bands?
Bollinger Bands are a technical analysis tool used to measure the price volatility of a cryptocurrency and identify potential trading entry and exit points. It consists of three lines plotted on a price chart: the Upper, Middle, and Lower bands.
- The Middle Band signifies the simple moving average (SMA) of the cryptocurrency’s price, typically calculated over a 20–day period.
- The Upper Band is the sum of the two standard deviations of the middle band.
- The Lower Band is the difference between two standard deviations from the middle band.
The distance between the upper and lower bands expands and contracts based on market volatility, widening during high volatility and narrowing during low volatility.
How Do Bollinger Bands Work In Crypto Trading?
Bollinger Bands help crypto traders identify overbought and oversold conditions. When the price touches or breaks the upper band, the asset is considered overbought, signalling a potential sell opportunity.
Conversely, when the asset’s price touches or breaks the lower band, then it is considered oversold, indicating a potential buy opportunity.
They are employed in various trading strategies to time entry and exit points, especially in swing trading and scalping. A common approach is to buy a token when the price hits the lower band and sell when it reaches the upper band.
Applying Bollinger Bands In Crypto Trading
Here is how Bollinger Bands are applied across various crypto trading strategies:
1. Mean Reversion (Bollinger Bounce)
Whenever the price of a token touches the upper or lower Bollinger Band, traders will be expecting possible trend reversals. If the price hits the upper line, it may be considered overbought, signalling a potential sell or shorting opportunity.
Conversely, if the price touches the lower band, it may indicate an oversold condition, which is a buying opportunity. The middle band, which is usually a 20-day Simple Moving Average (SMA), often serves as a profit target, with trades opened against the band and closed at the mean.
2. Breakout Trading (Bollinger Squeeze)
A Bollinger Squeeze occurs when the bands contract tightly, indicating low volatility and an upcoming price breakout.
Traders look for strong price movements outside the bands, which signal the beginning of a new trend. Entry is often taken in the direction of the breakout, with stops set just inside the bands.
3. Trend Following
When the bands expand and price consistently rides the upper or lower band, it signals a strong trend. In such cases, traders may enter in the direction of the trend, using the bands to trail stop-losses or to signal when the trend is losing momentum.
4. Combining with Other Indicators
Bollinger Bands are often paired with momentum indicators like the Relative Strength Index (RSI) or MACD to filter out false signals. For instance, a buy signal is stronger if the price touches the lower band and RSI is below 30 (oversold).
Similarly, a sell signal is more reliable if the price hits the upper band and RSI is above 70 (overbought).
Support and Resistance in Consolidation
In sideways or consolidation markets, the upper and lower bands act as dynamic support and resistance levels. Traders may buy at the lower band and sell at the upper band, targeting the middle band for exits.
How Are Bollinger Bands Created?
Bollinger Bands are constructed using the simple moving average and standard deviation, which are their fundamental building blocks.
They provide investors with valuable information regarding the crypto’s price volatility and potential trading opportunities in the market.
Here is how to create Bollinger Bands on the price chart:
1. Calculate the SMA
Typically, traders select a specific time frame for analysis based on the strategy they use. During that time period, they compile the previous closing prices of the preferred cryptocurrency. The SMA is the aggregated closing prices for the duration, which is then divided by the number of data points.
For example, if analyzing the daily closing price for a cryptocurrency over a 20-day period, the closing prices for each day are added and then divided by 20 to find the SMA.
2. Calculate the Standard Deviation (SD)
Once the SMA has been calculated, traders determine the standard deviation of the closing prices during the same period, which is pivotal for assessing price volatility in the crypto market. SD is used to determine the dispersion or variability in prices relative to the SMA.
3. Create the Upper and Lower Bollinger Bands
The upper Bollinger Band can be produced by multiplying the SMA by the SD. For the lower Bollinger Band, the same multiple of the SD is subtracted from the SMA.
4. Plotting Bollinger Bands on a Price Chart
After the SMA, SD, and upper and lower Bollinger Bands have been calculated, traders can plot them on a price chart. A channel is created around the price chart when the upper and lower bands are plotted above and below the SMA, with the middle band representing the centreline of the SMA.
5. Implementation
By interpreting price signals, traders will be able to comprehend trading cryptocurrencies using the Bollinger Bands. When the token’s price moves outside the upper band, it may be in an overbought condition, meaning that it is a selling opportunity.
If the price moves outside the lower band, then its market is oversold, presenting a buying opportunity. The width of the bands provides detail about market volatility, with wider bands indicating greater volatility and narrower bands signalling lower volatility.
Also Read: How to Keep Your Crypto Safe from Hackers
Benefits and Risks of Bollinger Bands
While Bollinger Bands are an effective tool for trading cryptocurrencies, they come with their fair share of benefits and risks, which we will touch upon in this section.
Benefits
- Bollinger Bands provide a clear, visual representation of price volatility, helping traders quickly assess whether a market is experiencing high or low volatility.
- They can be applied to any asset class and on any time frame, making them suitable for a wide range of trading strategies and markets.
- The bands help traders spot potential overbought and oversold conditions, which may signal reversals or continuations in price trends.
- Traders can adjust the period and standard deviation parameters to suit their trading style or the specific asset’s volatility.
- Bollinger Bands are straightforward and visually intuitive, making them accessible for traders at all experience levels.
- The bands can automatically expand and contract based on market volatility, adapting to changing market conditions, requiring no manual intervention.
Risks
- Bollinger Bands are based on moving averages and historical data, so they react to price changes rather than predict them. This could result in delayed signals, especially in fast-moving markets.
- During sideways or low-volatility markets, Bollinger Bands can generate false breakouts or misleading signals, potentially leading to losses if used alone.
- The indicator should not be used in isolation. It is most effective when combined with other technical tools to confirm signals and reduce the risk of false alarms.
- While they work better in ranging or sideways markets, the bands may be less effective in strong trending environments, where prices can “ride” the bands for extended periods.
- The effectiveness of Bollinger Bands can vary depending on the chosen parameters, which may require frequent adjustments for different assets or market conditions.
- Bollinger Bands are purely technical and do not account for external factors like new events or fundamental analysis, which can significantly impact price movements.
Conclusion
Bollinger Bands are an important analytical tool for crypto traders, helping them visualize volatility and identify potential buying and selling opportunities in the market. However, they should be used with caution and always in combination with other indicators or analysis methods for effective trading and risk management.
The information provided in this article is for educational and informational purposes only and should not be taken as investment advice. It is recommended that you conduct your own research and consult with professionals before making any trading or investment decisions, especially in highly volatile environments like the crypto market.
