Bollinger Bands Explained: How to Use Them in Crypto Trading
Bollinger Bands are useful technical indicators renowned for their effectiveness in assessing market volatility and guiding traders on entry and exit points. With a history spanning decades, these technical indicators have earned their reputation as a key tool for trading in different markets. In this article, we’ll explore what Bollinger Bands are and how they can be utilized in crypto trading. Let’s take a look:
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What are Bollinger Bands?
Bollinger Bands, named after the renowned American asset manager and technical analyst John Bollinger, first came on to the scene as a useful tool for stock analysis in the 1980s. Their adaptability has since put them among the most used tools in both traditional and crypto markets. Given crypto markets’ inherent volatility, indicators like Bollinger Bands can add a lot to your trading strategy. Constructing Bollinger Bands involves three key components. Let’s break down these three components for a deeper understanding of Bollinger bands:
Honored to have met John Bollinger at the CMT conference last month in Dubai. He’s one of the greats who I look up to in the world of technical analysis.
Upper Band:
Also referred to as the upper Bollinger Band, this band indicates a price level set at two standard deviations above the middle band or the moving average. By capturing about 95% of price action, it helps traders gauge volatility and identify potential overbought conditions near the upper bands. Calculating the upper band involves adding two standard deviations to the 20-day simple moving average (SMA) of the asset’s price. This band assists traders in timing entry or exit points for long and short positions.
Middle Band (SMA):
The middle band acts as a central point, showing the average price of the asset over a set time using a simple moving average (SMA). It reflects the average price within the chosen timeframe. To calculate the SMA, you simply average the closing prices within the chosen timeframes. This helps traders understand price trends and potential points where the trend might change direction.
Lower Band:
On the other hand, the lower Bollinger Band mirrors a price level set at two standard deviations below the middle band, acting as a moving average. Understanding the lower bands allows traders to identify consolidation phases and anticipate potential breakout or reversal trends.
When the upper and lower bands converge, indicating low volatility, it often is an indicator of a breakout. Traders use this indicator to make better decisions regarding asset purchases or sales.
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How Are Bollinger Bands Calculated?
Calculating Bollinger Bands revolves around a 20-day Simple Moving Average (SMA). Initially, the closing prices of the first 20 days are used as the basis for this calculation. Then, a rolling average is computed by adding each day’s price while overlooking the earliest one. This simple formula ensures that the 20-day SMA accurately reflects the changing price trends of the cryptocurrency.
Once the 20-day SMA is determined, the next step involves calculating the standard deviation of the cryptocurrency’s prices. This standard deviation offers an important look into price variability, allowing traders to gauge the market volatility.
Here are the formulas for each Bollinger band:
Upper band: SMA + (Multiplier x SD)
Middle band: (Sum of closing prices over a specified period) / (Number of periods)
Lower band: SMA – (Multiplier x SD)
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How to Use Bollinger Bands In Crypto Trading?
In crypto trading, Bollinger Bands can prove immensely helpful in technical analysis as they allow traders to gauge the following:
Assessing Volatility:
By observing the width of the bands, traders can learn about the level of price volatility. Wider bands suggest higher volatility, which can present more trading opportunities. On the other hand, narrowing bands indicate lower volatility, which could indicate possible price consolidation or trend changes.
Identifying Overbought and Oversold Conditions:
Bollinger Bands helps spot overbought and oversold situations. When the price surpasses the upper band, it may indicate overbought conditions. This means that the price might go down in the near future. Similarly, if the price falls below the lower band, it could signal oversold conditions, hinting at potential buying opportunities. When the price is above the band, it usually means it’s a good time to sell, and when the price is below the band, it’s an excellent time to accumulate.
Determining Trend Direction:
Traders use Bollinger Bands to identify the current trend. If the price consistently moves along the upper band, it may indicate an uptrend, while frequent touches or closeness to the lower band could signal a downtrend.
Generating Reversal Signals:
Bollinger Bands can also give you signals for potential trend reversals. For example, a price movement outside the bands followed by a reentry may indicate a reversal from an overextended condition. If this happens below the lower band, then it’s a signal for a downtrend, and if it happens above the upper band, then it’s a signal for an uptrend.
What Is a Bollinger Squeeze?
When the upper and lower bands of Bollinger Bands draw closer to the price, it signals a phenomenon called the Bollinger Squeeze. This squeeze indicates low market volatility, with prices moving within a narrow range.
During a Bollinger Squeeze, traders often remain patient, awaiting a breakout that could indicate a change in market direction. A breakout above the upper band typically suggests a potential continuation of an upward trend. On the other hand, a breakout below the lower band may indicate a potential continuation of a downward trend. Reacting timely to a squeeze allows traders to take advantage of potential breakout opportunities.
What Is a Bollinger Bounce?
The “Bollinger Bounce” strategy is a tactic used to spot trend reversals with the help of Bollinger Bands. This approach comes into play when a cryptocurrency’s price touches either the upper or lower band and then rebounds quickly like a bounce.
In this strategy, Bollinger Bands can be seen as active support and resistance levels. The Bollinger Bounce is most effective when the market is experiencing consolidation and price movements are relatively stable.
When the cryptocurrency’s price bounces off the lower band, traders often look for buying opportunities, anticipating an upward movement. On the other hand, when the price rebounds from the upper band, it signals a selling opportunity, as then it’s an indicator of downward movement. By using the Bollinger Bounce strategy, traders can identify these bounce points and can trade accordingly.
How to Find Entry and Exit Points with Bollinger Bands?
Bollinger Bands can be used as a tool to identify entry and exit points in crypto trading, as mentioned above. Here’s a quick recap of how to do it:
Entry Points:
- When the price touches or breaks below the lower Bollinger Band, indicating an oversold condition, traders may consider it a buy signal.
- Similarly, if the price reaches or surpasses the upper Bollinger Band, signaling overbought conditions, traders may see it as a sell signal.
- It is crucial to keep in mind that further technical analysis and validation may be necessary.
Exit Points:
- If traders are long on a cryptocurrency and the price approaches the upper band, it may be a sign to close the position and take profits.
- Similarly, if traders are short and the price nears the lower band, it might be time to close out the trade.
- Again, it is wise to also use other technical indicators to validate these readings given by Bollinger bands. Always use a combination of technical indicators for your trading strategy to get multiple validations.
Conclusion:
In summary, Bollinger Bands provides traders with a valuable tool to enhance their trading strategies and analyze markets more effectively. Traders can improve their strategies by understanding the different elements of Bollinger Bands and adjusting them for various timeframes and trading approaches. Then, they can combine the reading with other technical indicators to get more validations. It is important to note that while Bollinger Bands are excellent indicators, they should not be the only indicator relied upon. Using multiple indicators can offer a more thorough trading approach and can help you make even better decisions.
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