Bollinger Bands are overlaid on a price chart to help traders’ assess the volatility in an underlying crypto asset’s price. The indicator is composed of a central moving average (simple or exponential), sandwiched between an upper band and a lower band. The two bands are plotted above and below the moving average at a predefined standard deviation away from the cryptocurrency price.
The width of the band is a very good indicator of the current volatility in the cryptocurrency market. The narrower the bands, the less volatile a market is, and vice versa. Furthermore, by comparing the location of price relative to the Bollinger Bands, a trader can also deduce if the asset is relatively over or under-priced.
How Are Bollinger Bands Calculated?
Well-known trader, analyst, John Bollinger developed the indicator in 1983 by using the below given formula –
Middle Band = 20 period Simple Moving Average (SMA)
Upper Band = 20 period SMA + (20 period Standard Deviation of price x 2)
Lower Band = 20 period SMA – (20 period Standard Deviation of price x 2)
The settings stated above were the ones that Bollinger himself used while developing the indicator. With the advancements in online trading platforms, traders have been successfully experimenting with different settings, both from a moving average and standard deviation point of view.
Since each market has its own inherent demand-supply dynamics, a “one-size-fits-all” indicator setting is neither logical nor profitable. Bollinger himself advocated making incremental changes to the standard deviation multiplier to find the one that best adapts to the market under consideration.
How Can Bollinger Bands Be Incorporated Into a Trading Strategy?
The most unique feature of Bollinger Bands is its ability to visually portray the volatility in an cryptocurrency’s price. As volatility begins to rise, the bands get wider. Conversely, a dip in volatility results in a narrowing of the gap between the two bands. Bollinger suggests that the best short-term trading results are achieved by integrating Bollinger Bands with chart patterns, the two most popular among which are detailed below:
M-Tops are bearish reversal formations, almost identical to the classical double top patterns, except that unlike a double top, the first high need not be equal to the second high. Traders should take note whenever an underlying asset forms a high above the upper band, followed by a move lower, whereupon bulls re-enter but fail to push cryptocurrency prices above the prior high, indicating that the buying pressure is waning. The M-top pattern is completed and confirmed once prices close below the last swing low.
Cryptocurrency Chart Example
The W-Bottom pattern is a bullish reversal formation that occurs after protracted cryptocurrency price weakness . It is inverse in shape to M-tops, and is made up of a swing low outside the lower band, followed by a bounce back towards the middle line. The pattern is completed when prices unsuccessfully attempt to plot a lower low. The inability to form a fresh trough indicates that selling momentum has declined. The change in trend is validated by a close above the last swing high.
Cryptocurrency Chart Example
Simple Bollinger Band Trading System
Since trending markets potentially offer the best opportunities to generate returns, using the Bollinger Band to trade in the broader market direction results in favourable risk reward ratios. An Average Directional Index (ADX) reading above 30 is used to zero in on assets that are strongly tending in one direction. When the +DI line is above the -DI line, the trend is up.
Contrarily, when the -DI line is above the +DI line, the trend is down. In case of an uptrend, we wait for cryptocurrency prices to retrace from the upper Bollinger Band to the middle line, and enter long on the first bullish candle. Similarly, during a downtrend, pullbacks from the lower Bollinger Band to the centre-line are ideal locations to go short.
Cryptocurrency Trade Example
The Final Word
There is no Holy Grail in cryptocurrency trading. Just like any other technical indicator, Bollinger Bands should not be used in isolation to generate trading signals. Combining the indicator with other supportive market evidence like the presence of nearby support-resistance zones, or the confluence of Fibonacci levels, will greatly increase the odds of success.