How to trade Bollinger Bands
Bollinger Band is a popular technical analysis tool used by traders to define high or low on a relative basis. Developed and named after by the US-based technical analyst John Bollinger in the 1980s, this tool has become a popular option for traders trying to predict future market behaviour - critical information when longing or shorting Bitcoin for example.
Structure of Bollinger Band
In essence, Bollinger Band consists of three different lines, where one sits below and one above the asset price. The third one, called the midline or centerline, is actually a simple moving average (SMA), whose value is usually set at 20 i.e. the closing prices of the last 20 periods divided by 20.
These two outer lines expand and contract depending on the volatility of the given asset. Markets tend to trade in bullish or bearish trends, or ranging and trading sideways. Hence, one of the reasons the Bollinger Band tool was designed is to monitor the price action more closely, by trading the channel that encompasses the trading activity from both sides.
Bollinger Band shows the level of activity surrounding the asset in question like BTC or ETH. If the price action hits the upper Bollinger Band, the tool suggests that the asset is overbought and that we may see a rotation from the current levels.
On the other hand, the tag of the lower line signals that the market trades in an oversold environment and we may expect a bounce. In a strong uptrend, the price tends to trade between the centerline and the upper line, and vice versa. In this case, traders see a cross below the centerline as a signal that the trend may be reversing.
The two main goals of this indicator are to convey the market message on the volatility and to define high (resistance) or low (support) on a relative basis. When the two outer lines are contracting and narrowing down, the volatility is lower, which usually means that the market is ranging and consolidating - the so-called “Bollinger Band squeeze”.
A sharp change in the market behaviour is likely to lead towards the squeeze breakout. Some traders use this as a signal that the consolidation phase is over and the market is breaking out. In this regard, they enter trades in the direction of the breakout and use the broken line as a support/resistance.
Trading Bollinger Band in crypto markets
As mentioned earlier, there are two generally accepted strategies that include the Bollinger Band. One group of traders prefers to use Bollinger Band to define support and resistance lines. If penetrated, these lines are then used to trigger trades.
This group of traders believes that the break of the upper or lower trend line is just the beginning of a bigger trade. The aim is to take advantage of rapid price moves caused by high trading volumes and high volatility.
The BTC price chart above shows the break of the lower band which offers a trading opportunity. The distance between the price action and lower/upper band is never long, as the channel constantly adjusts based on previous closing prices.
The second group uses the centerlines to define shifts in trends. Any move above/below the centerline towards one of the two outer lines is seen as a shift in the trend, as the move across the centerline triggers the trade. In this case, two outer lines are used as profit-taking levels. If the asset price comes back above/below the centerline, the trade is invalidated.
This strategy generates more trades as moves above/below the centerline happen quite often. On the second Bitcoin price chart the price action trades below the centerline as it almost tagged the supporting line.
As the bears are unable to penetrate the support, the price rotates higher. If you entered a trade when the first daily candle closes above the centerline, and took profits on the first touch of the upper line, you would have gained 10%.
- Bollinger Band is an analytical tool, closely associated with the volatility, used by traders to define high or low on a relative basis.
- It consists of three different lines, where one sits below and one above the asset price. The central one is called the midline or centerline.
- Two outer lines expand and contract depending on the volatility of the asset.
- There are many different strategies based around Bollinger Band - two of those strategies are outlined above.