A tool developed by Bollinger to help in the recognition of systemic pattern recognition in prices; it is a band that is plotted two standard deviations away from the simple moving average, or exponential moving average in some cases.
What Is a Bollinger Band?
A bollinger band is a technical analysis tool named after the esteemed technical trader who designed it — John Bollinger. Bollinger bands consist of three lines:
- A simple moving average (usually defaulted to 20-period moving average)
- An upper band (usually defaulted to two standard deviations above the 20-period moving average)
- A lower band (usually defaulted to two standard deviations below the 20-period moving average)
- A bollinger band is commonly used as a visual indicator for estimating the volatility of a charted asset.
- A bollinger band consists of three lines: a simple moving average, an upper band and a lower band.
- Of the two common trading strategies using bollinger band, breakout trades are more relevant for cryptocurrencies, due to the high volatility of the asset class.
As shown in the chart above, bollinger bands are applied to the daily chart of BTC/USD traded at Coinbase. The upper band is plotted two standard deviations above the 20 period MA, while the lower band is plotted two standard deviations below. Standard deviation measures the difference between a group of values from the mean, making it a good indicator of volatility. As the bands expand, it indicates that the market is becoming more volatile as prices move away from the lagging 20 MA. As bands contract, it indicates that the market is becoming less volatile.
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!
How Are Bollinger Bands Calculated?
The formula to calculate bollinger bands are as follows:
Middle Band = MA[Source Price, n]
Upper Band = MA[Source Price, n] + (m * n period standard deviation)
Lower Band = MA[Source Price, n] – (m * n period standard deviation)
Where source price can be open, high, low, close, etc. (chosen by user)
n = number of periods (chosen by user)
m = standard deviations (chosen by user)