This article outlines how to use the technical analysis tool Bollinger Bands, developed by trading veteran John Bollinger in 1983. The Bollinger Bands tool has stood the test of time, with Bollinger frequently analysing and commenting on cryptocurrency markets.
What are the Bollinger Bands?
The Bollinger Bands are based on volatility, which is somewhat cyclical and predictable. Low volatility environments eventually lead into periods of high volatility, and vice versa.
The Bands are composed of a simple moving average (20-period by default) and an upper and lower band that are set at 2 standard deviation by default.
You can use the Bollinger Bands when trading on the Interdax platform. When on the trading chart, click on Indicators then scroll down (or type Bollinger Bands in the search box) and click on the ‘Bollinger Bands’ indicator. You can click on the screw symbol on the upper left hand side of the chart to change the settings of the Bollinger Band, as well as the colour.
Bollinger Bands on the Interdax platform
How to Use the Bollinger Bands
There are several strategies that can be used to trade cryptocurrency with the Bollinger Bands, outlined below.
Trading ‘W’ Bottoms with the Bollinger Bands
‘W bottoms’ should be used to setup a long position, entered once there is a display of strength in the asset.
For a valid ‘W bottom’ pattern, we should look for the first low (usually outside of the Bollinger Bands) to be lower in relative terms as compared to the second low (always inside of the Bands).
Volume should also be higher on the first decline. The second low does not have to be beneath than the first, and even if it does drive to a new low in price, if it remains inside the Bollinger Bands then it is not a new low on a relative basis. A W bottom pattern is invalidated if the second low is beneath the lower band.
The chart above shows an example of a W bottom for BTC-USD. Following the second low inside the Bands, a bullish candlestick was printed which closed at $7,630 which would have motivated an entry into a long position. A stop would have been placed just below the second low around $7,465. BTC-USD went on to reach highs near $9000 following the W bottom.
Trading ‘M’ Tops with the Bollinger Bands
‘M tops’ should be used to set up a short position, but require more confirmation than a bottom. Enter the short once there is a display of weakness.
M top patterns consist of a rally, then a pullback, a test of the resistance established by the highs of the preceding rally, then followed by the start of a downtrend. A triple top, also known as a head and shoulders pattern, is also very common.
Volume in a head and shoulders pattern typically rises on the left side of the pattern, wanes across the middle then increases again as the downward move gets underway.
The chart above illustrates an example of a M top. The first high is outside of the Bands while the second high is inside the Bands. Volume is larger on the first high but declines on the second high, suggesting that interest in an upward move is dwindling. Following the second high, a large bearish candlestick was printed and the swift momentum should have signalled to the trader to enter a short position. With an entry around $12,900 the price eventually fell to a low near $10,000.
The Bollinger Squeeze
The ‘Bollinger Squeeze’ can be identified with Bollinger Bands and the BandWidth indicator. ‘The Squeeze’ allows us to identify and trade the breakout at the beginning of a trend.
Once the price closes above the upper (or lower bands) when they are constricted tight together, then we have a breakout and can buy (or sell) using this signal. As volatility returns to the market, a new direction is usually established. In trending markets, price action can climb up the upper band (or climb down the lower band), and is known as walking the band.
To identify Bollinger Squeezes, we can use an indicator derived from the Bollinger Bands - known as BandWidth. The BandWidth indicator tells us how wide the bands are (calculated as the difference between the upper and lower band, all divided by the middle band) and was created to measure the Squeeze.
For a squeeze, generally we should look for the lowest BandWidth reading in six months.
Once you've entered a position, you can use the lower or upper band as a stop to limit your losses. To reduce the risk of trading head fakes, we can combine the Bollinger Bands and BandWidth with volume indicators such as the Money Flow Index, Intraday Intensity or Accumulation-Distribution.
The Bollinger Bounce
The ‘Bollinger Bounce’ is a reversal strategy.
We look for a buy position once the price action touches the lower band and an oscillator (such as the MACD) is positive. We look for a sell positions once the price actions touches the upper band and an oscillator is negative, as shown below.
Any Bollinger bounces should confirmed with a volume oscillator, such as the Market Facilitation Index or the Volume-weighted MACD, and if it has a similar pattern, then it provides confirmation to buy on the first strong up candlestick. If the volume oscillator does not display a W bottom, then we should wait for another setup.
For tops, we would want more confirmation than for a bottom, as they usually tend to take longer to form. The b% indicator should be lower on each push and confirmed by a volume indicator.
To learn about the Bollinger Bands in more depth, Interdax recommends the book Bollinger on Bollinger Bands for further information.