Bollinger bands are a technical analysis tool developed by John Bollinger in the early 1980s. This metric is made up of the simple moving average and the upper and lower band of the standard deviation of the average trend lines. When you use Bollinger bands you can observe if a cryptocurrency is oversold or overbought, as well as possible signals of asset volatility. Bollinger bands are also considered a lagging indicator, meaning that the metric only infers informations following a shift. With Bollinger bands, traders can confirm whether a shift in long-term trend has occurred or not. We wanted to make a Bollinger Bands crypto trading guide to help you understand one of the most reliable indicators ever created.
Making the Bollinger Bands
Bollinger bands are made up of three lines which are a simple moving average and an upper and lower band. To calculate the moving average, you must start by setting the frame over which you are going to calculate it, the standard time frame spans 20 periods, however, this can vary. The longer the time span you use, the smoother, but less sensitive the fluctuations are. Once the value of the moving average is determined, the upper and lower bands are plotted, which are typically two standard deviations from the mean.
Bollinger Bands Rules
The Bollinger bands have three rules to interpret what this indicator is telling you. But remember, you’ll always need to confirm your assumptions with the price! Learning how to use Bollinger Bands will be a great step in the right direction to improve your crypto and stock trading habits.
Rule 1. The calm before the storm
The first rule to understand the Bollinger bands pertains to the constriction of the bands. When you see the bands narrowing, you can expect a sharp price movement in either direction. This happens because there is calmness in the market until inverstors buy or sell a cryptocurrency. Then the storm hits, as prices suddenly react to investor movement. As a result, price volatility rises and the bands begin to diverge..
Rule 2. Tendency expected to continue if the price exceeds a band
When the price of a crypto asset trades close to or at the bands, this indicates that there is healthy market momentum. The price will follow the trend as more buys come in from traders. On the other hand, if the price crosses a band multiple times, that means trend exhaustion, where prices make a short term pullback and continue the trend.
A distinct way to interpret this rule is like the RSI overbought/oversold indicator. The upper band is the overbought side while the bottom one, the oversold side. The moving average (the middle line) is the frontier between both sides.
Rule 3. When the price makes a change of trend pattern after crossed a band, expect a trend reversal
After reaching its all-time high, Bitcoin’s price started to form a reversal pattern. First, the price dropped below the previous low, generating a pullback to the upside and causing a lower high compared to the previous high. Finally, the expectation of a downtrend is confirmed when the price broke the support line, marked in orange.
As you see, prices going above the upper band is an overbought sign, so the trend reversal has more probabilities to occur.
In conclusion, Bollinger bands are a technical analysis tool, where the upper and lower bands vary in width. When the market becomes unstable, the bands become wider, while in periods of stability they become narrower. With this tool you can predict market trends and identify whether an asset is oversold or overbought; however it is recommended not to make a decision based only on this indicator and it is suggested to complement the analysis with techniques such as the relative strength index (RSI), and take into account external factors, which significantly influence the cryptocurrency market.