For newer cryptocurrency traders, learning how to successfully time market entries and exits is a fundamental challenge. It’s also often a difficult one, given the considerable volatility of the market. Technical trading tools help level the playing field, giving traders access to indicators that can help identify developing market trends and opportunities.
One of the most popular and useful of these indicators are Bollinger Bands. To help you learn more about this indicator and its trading strategies, let’s take a closer look at Bollinger Bands meaning and what they indicate in cryptocurrency trading.
Bollinger Bands Meaning
The Bollinger Bands (BB) were created in the early 1980s by financial analyst and trader John Bollinger. They are broadly used as an instrument for technical analysis (TA). Basically, the Bollinger Bands work as an oscillator measurer. It indicates whETHer the market has high or low volatility, as well as overbought or oversold conditions.
How Do Bollinger Bands Work?
The main idea behind the BB indicator is to highlight how prices are dispersed around an average value. More specifically, it is composed of an upper band, a lower band, and a middle moving average line (also known as the middle band). The two sidelong bands react to the market price action, expanding when the volatility is high (moving away from the middle line) and contracting when volatility is low (moving towards the middle line).
How Are Bollinger Bands Calculated?
The standard Bollinger Bands formula sets the middle line as a 20-day simple moving average (SMA), while the upper and lower bands are calculated based on the market volatility in relation to the SMA (which is referred to as standard deviation). The standard settings for the Bollinger Bands indicator would look like this:
- Middle line: 20-day simple moving average (SMA)
- Upper band: 20-day SMA + (20-day standard deviation x2)
- Lower band: 20-day SMA - (20-day standard deviation x2)
The setting acknowledges a 20-day period and sets the upper and lower bands to two standard deviations (x2) away from the middle line. This is done to ensure that at least 85% of the price data will be moving in between these two bands, but the settings may be adjusted according to different needs and trading strategies.
How Do Traders Use Bollinger Bands?
As bollinger bands measure volatility, or lack thereof, there are two ways that traders can construct strategies around them.
Using Bollinger Bands for Mean Reversion
The first way traders utilize bollinger bands is to wait for the market to approach the upper or lower bands before taking action. As the price trades closer towards the bands, the possibility becomes greater that the market is overbought (upper band) or oversold (lower band). Hence, the mean reversion trader will execute a short when the price touches the upper band, and a long when the price touches the lower.
Caution: this simplistic strategy may not be the most applicable for explosive and trending markets like Bitcoin or cryptocurrencies. Mean reversion may be more suited for less volatile markets.
Using Bollinger Bands for Breakout Trades
The second way traders utilize Bollinger Bands is to trade breakouts. This is done by executing a trade in the direction that the price breaches the band. If the price breaches the top band, enter a long position, and if price breaches the lower band, enter a short. This is best executed in tandem with the bands narrowing, which could be a good signal that the market is readying itself for an explosive move.
A simple strategy would look somETHing like this:
- Wait for the price to reach the top (bottom band). Execute a long(short) position when it does.
- Use a trailing stop with the 20 MA as stop-price. Move the stop every time the MA shifts.
- Exit the trade only when price re-touches the 20 MA.
Using bollinger bands for breakout trades on Bitcoin or other cryptocurrencies is recommended over mean reversion trades, as cryptocurrencies are extremely volatile and tend to trend for prolonged periods. Do your own research before trading!
Closing Thoughts
Bollinger Bands are a cornerstone technical trading tool used by vast numbers of traders every day to identify developing trends and opportunities in the cryptocurrency market. Now that you have a base understanding of Bollinger Bands meaning, further studying their trading formations can help you determine whETHer a digital asset is overbought or oversold, and inform your trading decisions accordingly.
