trading is neither an exact science nor an art. it is a mixture of both. there are dozens of indicators publicly available and each one claims to be the best. however, none of them are perfect or designed to be used in isolation.
One of the most popular indicators widely used by various traders is Bollinger Bands, an indicator that can be used to spot price highs and lows and opportunities to short during exhausted rallies and to buy during sharp pullbacks.
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Let’s learn three simple methods to use this indicator in trading.
what are bollinger bands?
John Bollinger created and copyrighted Bollinger Bands in the 1980s. The indicator consists of a middle band, which is a simple moving average whose default value is set to 20 periods, and two outer bands set two standard deviations below and above the mean band.
Its most basic use is to identify whether the price is high or low on a relative basis. If the price is above the upper band, the asset is perceived to be overbought. On the other hand, if the price dips below the lower band, the coin is believed to be oversold.
However, many traders make the mistake of assuming that the price of the asset will fall when it reaches the upper band, or that a rally will start when the price reaches the lower band.
This usually only happens when price is stuck in a range. As with any indicator, assumptions can easily lead to big losses in a trending market, so looking for the confluence of a number of metrics is still good practice.
let’s look at some ways traders use bollinger bands.
bollinger bands can detect volatility pressures
according to john bollinger, assets switch between phases of low volatility and high volatility. therefore, after periods of low volatility, traders can expect volatility to spike, which could result in trending movements.
The above chart shows how XRP’s volatility dropped sharply between mid-September to mid-November 2020, marked as an ellipse on the chart. After about two months of this low volatile phase, the volatility shot up and the XRP/USDT pair offered an excellent trading opportunity.
In the above example, Binance Coin (BNB) was in a downtrend and the volatility tightened between the end-September to mid-November 2018, marked as an ellipse on the chart. Here, the volatility expanded to the downside and the BNB/USDT pair resumed its downtrend.
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A volatility squeeze does not predict the direction of the next breakout. Sometimes market makers push the price above the upper band and below the lower band, trapping novice traders. therefore, traders can avoid getting ahead of the direction and wait for price to break above resistance or below range support before establishing a position.
The above chart shows how the overly eager bulls and bears can become trapped. On Oct. 22, 2020, the bulls pushed the price above the upper band but could not clear the resistance at $5.77. After a few days on Nov. 3, 2020, the price pulled below the lower band but did not break the support at $4.58.
classic ethereum (etc.) broke above $5.77 on Nov 1st. 18, 2020, but it was not a perfect trade as the price did not start a strong uptrend. the market makers were chasing the stops from the buyers and also tried to catch the bears with the sharp drop on December 1st. January 23, 2020.
However, the price quickly climbed back above the lower band on December 12th. 24, 2020, and the etc/usdt pair soon started a strong bullish move.
hence, instead of relying solely on the bollinger bands signal, traders should also look for confirmation from other supportive indicators or use support and resistance lines.
bollinger bands can signal when to buy during a pullback
A pullback in an uptrend is often a buying opportunity as the main trend tends to reassert itself. When the middle band is sloping up and the price is trading in the area between the middle band and the upper band, it is a bullish trend signal. In this scenario, traders can wait for the bounce off the middle band to initiate long positions.
Litecoin’s (LTC) chart shows the start of an uptrend in mid-February 2019 as the middle band turned up and the price traded between the middle band and the upper band. After that happens, traders may attempt to buy the rebound off the middle band and keep the stop-loss just below the swing low.
There were five possible entry opportunities for a conservative trader. four of them turned out to be winners, but one would have made it to the stops. this shows how no strategy is perfect, therefore a stop-loss should always be used to limit risk.
Solana (SOL) turned down from above the upper band on Sep. 1, 2020, and broke below the middle band on Sep. 3, 2020. Since then, the price largely remained inside the lower band, which turned down on Oct. 2, 2020. That confirmed the downtrend and gave an opportunity to traders to short on Oct. 13, 2020, as the downtrend resumed, following a move to the middle band.
two bollinger bands can be used to trace strong uptrends
One of the most profitable ways to trade is to buy and hold during strong uptrends. however, this is easier said than done because many traders are selling too soon out of fear and others are still waiting for the drop.
This is where Double Bollinger Bands can come in handy. its use has been popularized by kathy lien, managing director of fx strategy for bk asset management.
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To build the settings, traders use the default value for the first bollinger bands. for the second bollinger bands, keep the same value of the moving averages in the 20-day simple moving average, but reduce the value of the standard deviation of the outer bands to 1.
As shown above, in an uptrend, the aim is to buy when the price trades between the upper band of the first and second Bollinger Bands.
There are several possible entry opportunities and a trader would wait for the price to close between the upper bands for three consecutive days before buying, because this can help avoid unforeseen swings.
traders can keep the initial stop-loss below the middle band, but raise it quickly to reduce risk and protect profits. one of the possible exit strategies would be to sell on a close below the upper band of bollinger bands with one standard deviation.
The chart above shows how the strategy is used. traders may have entered Dec. on January 19, 2020, and remained in business until the stops arrived on January 1. 11, 2020. Another buying opportunity came up on Feb. 7, which finally hit the stops on February 2. 23.
This strategy should be avoided when the price is trading in a range, and to improve the odds, traders can only open new positions when the price breaks through a strong overhead resistance.
key points
Bollinger bands can be a good tool to help traders identify a trend early by spotting the volatility contraction, which is usually followed by a volatility expansion and a trend phase.
Even if a trader didn’t buy early, Bollinger Bands can be used to join the trend during pullbacks with a low risk entry opportunity.
The indicator can also be useful for trading in a strong trend phase where corrections are shallow.
There are many different ways to use bollinger bands and this article just provides some guidelines that traders can explore.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of cointelegraph.com. Every investment and trading move involves risk, you need to do your own research when making a decision.
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