Bollinger Bands Explained: Definition, Purpose, Use in Crypto Trading

Bollinger Bands are widely used technical indicators by both professional and amateur traders alike. Developed by John Bollinger in the 1980s, they have proven to be a powerful tool for analyzing price movements and volatility in various financial markets, including cryptocurrencies.

In this guide, we’ll delve deep into Bollinger Bands and their application in cryptocurrency trading. We’ll tackle fundamental topics such as the definition and purpose of these bands, their origin, and historical development, as well as the key components involved in their calculation.

Additionally, we’ll examine popular trading strategies based on Bollinger Bands, such as identifying overbought and oversold levels, the squeeze strategy, and their use in detecting trends and price patterns.

Bollinger Bands Defined

Bollinger Bands are a technical indicator consisting of a central line representing a simple moving average (SMA) of an asset’s price and two additional lines: an upper band and a lower band. These bands are drawn at a distance determined by the standard deviation of the price from the moving average.

More specifically, the upper band is calculated by adding a multiple of the standard deviation to the moving average, while the lower band is obtained by subtracting the same multiple of the standard deviation from the moving average. This arrangement creates a channel that widens or narrows depending on the price volatility, providing valuable information to traders and investors.

One of the main functions of Bollinger Bands is to identify potential overbought or oversold levels. When the price approaches or exceeds the upper band, it is interpreted as a signal of overbought conditions, suggesting that the asset may be reaching excessively high levels and could be an opportunity to sell. Conversely, if the price approaches or falls below the lower band, it is considered a signal of oversold conditions, indicating that the asset may be undervalued and presenting a buying opportunity.

In addition to identifying overbought and oversold conditions, Bollinger Bands also provide information about market volatility. When the bands widen, it indicates increasing price volatility, which may signal a more active market and potential trading opportunities. On the other hand, when the bands contract, it suggests a decrease in volatility and possibly a period of consolidation or sideways movement in price.

It’s important to note that Bollinger Bands do not predict price direction but rather provide information about volatility and overbought or oversold levels. Therefore, they are commonly used in conjunction with other technical indicators and fundamental analysis to make better trading decisions.

Origin of Bollinger Bands

Bollinger Bands were developed in the early 1980s by John Bollinger, a renowned technical analyst and trader on Wall Street. Working as a financial market analyst at the time, Bollinger was seeking a way to enhance price volatility analysis and develop better trading strategies.

After experimenting with different approaches, Bollinger realized that by plotting lines on a price chart at a certain distance from a moving average, valuable information about market volatility could be obtained. This observation led him to combine the moving average with standard deviations, thus creating what would later be known as Bollinger Bands.

Bollinger Bands were formally introduced in an article published by John Bollinger in 1983 in the “Stocks & Commodities Magazine”. In this article, Bollinger explained how to use the bands to analyze price volatility and find trading opportunities based on overbought or oversold conditions.

Despite their apparent simplicity, Bollinger Bands quickly gained popularity among Wall Street traders and became a fundamental tool in technical analysis. The bands’ ability to dynamically adapt to market volatility and provide information about overbought and oversold levels proved to be extremely useful for traders.

While Bollinger Bands were initially designed for the stock market, their application quickly spread to other financial markets, such as futures, currencies, and more recently, the cryptocurrency market.

Today, Bollinger Bands are widely known and used in technical analysis, making their creator, John Bollinger, recognized as one of the most influential analysts in the field of financial trading.

Bollinger Bands Calculation

The calculation of Bollinger Bands involves three main components: the simple moving average (SMA), the standard deviation, and a multiple of the standard deviation. Each of these components plays a crucial role in the construction and operation of the bands.

Simple Moving Average (SMA)

The simple moving average is the central line of Bollinger Bands and represents the average of the asset’s closing prices over a specific period. This period, commonly known as the “time window”, can vary depending on the trader’s preferences and analysis objectives. Typically, a 20-period window (days, hours, etc.) is used, although traders can adjust this parameter as needed.

The SMA is calculated by summing the asset’s closing prices over the selected period and dividing that sum by the number of periods. For example, to calculate a 20-period SMA, the closing prices of the last 20 days would be summed, and that sum would be divided by 20.

Standard Deviation (SD)

Standard deviation is a statistical measure that quantifies the dispersion of prices relative to the simple moving average. In other words, it indicates how far prices are from the SMA. A higher standard deviation implies higher volatility, while a lower standard deviation suggests lower volatility.

To calculate the standard deviation, begin by computing the difference between each closing price and the SMA over the chosen period. Next, square each of these differences and sum them up. Finally, divide this sum by the number of periods and take the square root of the result to obtain the standard deviation.

Multiple of Standard Deviation (DE)

The multiple of the standard deviation determines the distance between the upper band and the lower band relative to the SMA. This multiple is used for both the upper and lower bands.

The most common standard setting is to use a multiple of 2, meaning that the upper band is plotted by adding 2 times the standard deviation to the SMA, while the lower band is plotted by subtracting 2 times the standard deviation from the SMA. However, traders can adjust this multiple according to their preferences and trading strategies.

Once these three components are calculated, Bollinger Bands are plotted on a price chart, where the central line represents SMA, the upper band is SMA + (Multiple of standard deviation × Standard deviation), and the lower band is SMA – (Multiple of standard deviation × Standard deviation).

Bollinger Bands Trading Strategies

Two of the most popular strategies based on these bands are the overbought and oversold strategy and the squeeze strategy.

Overbought and Oversold Strategy

This strategy is based on the concept that when an asset’s price approaches or exceeds the upper band of Bollinger Bands, it may indicate an overbought condition, suggesting that the asset may be reaching excessively high levels and may be prone to a correction to the downside. On the other hand, when the price approaches or falls below the lower band, it can be interpreted as a signal of oversold conditions, implying that the asset may be undervalued and presenting an attractive buying opportunity.

Traders employing this strategy aim to sell when the price reaches or exceeds the upper band, anticipating a downward correction in the asset. Conversely, they look to buy when the price touches or falls below the lower band, expecting an upward rebound.

It’s important to note that overbought and oversold signals don’t always result in immediate price reversals. In strong trends, it’s common for the price to continue its movement even after touching the bands. Therefore, combining it with other strategies provides better accuracy when executing a trade.

Squeeze Strategy

This strategy is based on the observation that periods of low volatility, represented by a narrowing of Bollinger Bands, often precede periods of high volatility and significant price movements.

When the bands contract and narrow, it indicates that market volatility has decreased and the price is moving in a relatively tight range. This compression of the bands is known as a “squeeze”.

Traders using this strategy aim to identify these compression periods and anticipate a breakout or expansion of the bands. When the price breaks out of the narrow bands, either above or below, it’s interpreted as a signal that volatility is increasing and a significant price movement can be expected.

Once the breakout of the narrow bands occurs, traders can look for entry opportunities in the direction of the movement, with properly adjusted stop losses. Additionally, they often use other confirmation indicators, such as trading volume, to support their entry decisions.

Using Bollinger Bands

One of the primary applications of Bollinger Bands in crypto trading is identifying overbought and oversold levels. When the price of a cryptocurrency approaches or exceeds the upper band of Bollinger Bands, it may signal that the asset is overbought and could experience a downward correction. Conversely, if the price approaches or falls below the lower band, it may indicate that the cryptocurrency is oversold and could present an attractive buying opportunity.

In addition to overbought and oversold signals, Bollinger Bands can also be used to detect trends and determine entry and exit points in trading operations. If the price consistently moves along the upper band, it may indicate a strong uptrend, while if the price stays near the lower band, it may suggest a downtrend.

Another useful application of Bollinger Bands in cryptocurrency trading is identifying patterns such as “W-bottoms” and “M-tops”. These patterns can provide valuable information about possible trend reversals and help traders anticipate changes in price direction.

Bollinger Bands should be tailored to match your trading style as outlined below:

• For short-term traders engaging in day trading, it’s recommended to set the Simple Moving Average (SMA) with a period of 10 days, accompanied by bands set at 1.5 standard deviations.
• Medium-term traders involved in swing trading can adjust their Bollinger Bands by setting the SMA with a period of 20 days, while keeping the bands at 2 standard deviations.
• For long-term traders focusing on position trading, it’s advisable to set the SMA with a period of 50 days, with bands set at 2.5 standard deviations.

Bottom Line

Bollinger Bands represent a multifaceted and powerful tool in the realm of cryptocurrency trading. Not only do they help identify overbought and oversold levels, but they are also useful for detecting trends and patterns, thus providing valuable information that can empower traders’ decisions and increase their chances of success in this highly volatile market.

As previously explained, when operating in any financial market, it’s crucial to avoid relying solely on a single indicator. In the specific case of cryptocurrencies, solid risk management and disciplined execution of trading strategies are essential to staying afloat and achieving consistent goals in this ever-changing environment.

Additionally, it’s essential to remember that in the world of trading, maintaining prudence and composure is key to safeguarding capital and capitalizing on opportunities in these markets characterized by their volatility.