If someone tells you that the Bollinger Bands indicator can help predict how high or low the price of a cryptocurrency might go in the near future, would you believe it? Well, you should, because that’s exactly what this technical analysis tool is designed to do. The primary purpose of the Bollinger Bands indicator is to provide a dynamic price range within a specific time frame, helping traders make more informed decisions.
Developed by John Bollinger in the 1980s, the Bollinger Bands indicator initially faced skepticism. Traders at the time were hesitant to adopt it due to its dynamic, non-static nature. However, over time, as markets evolved and volatility became a key concern, the indicator gained widespread trust and is now extensively used in all forms of trading, including cryptocurrency.
Its ability to adjust to market volatility in real-time makes it an invaluable tool for identifying potential entry and exit points. Whether you’re day trading Bitcoin or holding altcoins for the long term, this indicator can help you spot price squeezes, breakouts, and trend reversals with ease.
In this guide, we’ll break down the Bollinger Bands chart, explain how it works, and show you how to effectively use the Bollinger Bands indicator in your crypto trading strategy to maximize profits and minimize risks.
But before we dive in, it’s important to understand that while the Bollinger Bands indicator is easy to grasp visually, it is considered an advanced technical analysis tool. To use it effectively, you should have at least a basic understanding of crypto trading principles such as price action, support and resistance levels, and market trends.
What is the Bollinger Bands indicator?
The Bollinger Bands indicator is one of the most widely used technical analysis tools in both traditional and cryptocurrency markets. According to its creator, John Bollinger, “Bollinger Bands are curves drawn in and around the price structure, usually consisting of a moving average (the middle band), an upper band, and a lower band that answer the question of whether prices are high or low on a relative basis.”
To put it simply, Bollinger Bands form a chart with three lines:
The middle line is a moving average.
The upper band and lower band are standard deviations plotted above and below this average.
The two outer bands are especially important because they act like dynamic price levels. These bands expand and contract based on market volatility and help traders determine the potential price range of a cryptocurrency within a given time frame. When prices approach the upper band, the asset may be considered overbought. When prices fall near the lower band, it could be seen as oversold.
Interestingly, the name Bollinger Bands wasn’t pre-planned. When John Bollinger first introduced the indicator, it quickly gained attention for its accuracy and practicality. During a radio interview where he was explaining how the indicator works, the host asked, “What do you call those lines?” John hadn’t really decided on a name and tried to dodge the question, but the host persisted. Caught off guard and needing to answer, he simply added his last name and said, “Let’s call them Bollinger Bands.”
Structure of Bollinger Bands Indicator
The Bollinger Bands indicator visually appears like a tunnel or channel that wraps around the price candles on a chart. This tunnel is formed by three distinct lines:
- The upper band.
- The middle band (also known as the simple moving average or SMA).
- The lower band.
These three bands move dynamically based on the asset’s price and volatility. The bands expand and contract as the market becomes more or less volatile, helping traders gauge potential price movements.
- Upper Band
The upper band is calculated by adding two standard deviations to the asset’s 20-day simple moving average (SMA) by default. It represents the upper boundary of the typical price range, and when price candles approach this band, it may signal an overbought condition. - Middle Band (SMA)
The middle band is simply the SMA of the asset’s price over a selected time frame, typically 20 days. This line acts as the trend baseline, showing the average price and often serving as support or resistance, depending on the price direction. - Lower Band
The lower band is formed by subtracting two standard deviations from the SMA. It marks the lower boundary of the expected price range. If the asset’s price nears or touches this line, it might be considered oversold.
While the Bollinger Bands indicator doesn’t come with a fixed color scheme or default time break, most trading platforms allow users to customize these options. A common and reliable setting is.
- Time frame: 20 periods (often 20 days).
- Standard deviation: ±2
This setup is widely used because it captures approximately 95% of price movement under the assumption of a normal distribution. However, you can tweak the standard deviation or time frame based on your strategy. Keep in mind that altering these settings can significantly change the indicator’s sensitivity and may lead to misleading signals if not done carefully.
What Do Bollinger Bands Tell You?
The Bollinger Bands indicator is not designed to predict exact price levels but rather to provide insights into market momentum, volatility, trading volume, and sentiment. According to John Bollinger, there are 22 foundational rules that help traders interpret the Bollinger Bands strategy correctly. While you don’t need to memorize them all, understanding the key concepts can significantly improve your trading decisions.
In essence, the Bollinger Bands indicator helps traders identify whether a cryptocurrency is overbought or oversold, and it highlights potential trend reversals or breakout opportunities.
When the price approaches or touches the upper band, it often suggests that the asset may be overbought, signaling a potential sell opportunity.
Conversely, if the price falls toward or touches the lower band, it may indicate that the asset is oversold, which could be a good buying opportunity.
However, John Bollinger himself cautions that a price crossing above the upper band or below the lower band should not automatically be treated as a buy or sell signal. The market can continue to move beyond those bands, so it’s essential to analyze other indicators or price action before making a decision.
One important concept in the Bollinger Bands strategy is the “squeeze.” This occurs when the upper and lower bands start to contract toward the middle band (the simple moving average). A squeeze signals low volatility and is often a precursor to a significant price movement—either upward or downward. In crypto trading, a squeeze is usually seen as a bullish indicator if followed by strong volume and upward breakout momentum.
Calculating Bollinger Bands.
Calculating the Bollinger Bands indicator involves a mathematical process, but once you understand the logic, it’s straightforward. To begin, you’ll need historical price data for the cryptocurrency you want to analyze. This includes the closing prices, and optionally, the high and low prices.
You can easily collect this data from trusted platforms like CoinMarketCap.com. Simply search for the crypto coin of your choice, go to its “Historical Data” tab, and download the prices based on your preferred time frame. If you’re comfortable using Excel, you can quickly calculate the Bollinger Bands indicator using this data.
To calculate the Bollinger Bands, follow this standard process:
Step 1: Calculate the Moving Average (MA)
This is typically a 20-day simple moving average (SMA).
Formula:
MA = (Sum of closing prices over the period) / (Number of periods)
Step 2: Calculate the Standard Deviation (SD)
This measures the volatility of the price around the moving average.
Formula:
SD = √[(Σ (Price – MA)²) / (Number of periods)]
Step 3: Calculate the Upper and Lower Bollinger Bands
These bands are placed above and below the MA using the SD.
Upper Band = MA + (2 × SD)
Lower Band = MA – (2 × SD)
How to Make Profits Using the Bollinger Bands Indicator?
The chart below illustrates how the Bollinger Bands indicator, when combined with the Stochastic Oscillator, can help traders identify profitable crypto trading opportunities. This example highlights the behavior of Ethereum (ETH) and how technical indicators can guide precise buy and sell decisions.
As mentioned earlier, when the upper and lower Bollinger Bands are close together, it indicates a period of low volatility, commonly referred to as a “squeeze.” This often signals a potential breakout, usually in the upward direction if supported by other indicators.
In our example, we observe that the Bollinger Bands are narrowing, and the Stochastic Oscillator is at 16%, which suggests that the asset is oversold. Based on this signal, we decide to buy Ethereum at $1549. At this time:
- The upper Bollinger Band is at $1566.
- The Stochastic reading is low at 16%, indicating bullish potential.
The Setup:
- Buy Price: $1549
- Stochastic: 16% (oversold)
- Upper Band: $1566 (a resistance level to watch)
As time progresses, the Bollinger Bands start to widen, which indicates increasing volatility and a potential price move. About 10 hours later, the price of ETH crosses above the upper band, and the Stochastic Oscillator hits 98%, well above the overbought threshold of 80%.
This is a strong signal to sell the position.
The Exit:
- Sell Price: $1628
- Upper Band: $1630
- Stochastic: 98% (strong overbought signal)
By subtracting the buy price ($1549) from the sell price ($1628), we made a profit of $79 per ETH in just a few hours.
Limitation of Bollinger bands
The Bollinger Bands indicator does not provide fixed buy or sell signals; it only displays the momentum range of an asset, which can be risky if misinterpreted. It reflects how volatile the price is, but not necessarily where it’s headed next.
Additionally, the Bollinger Bands indicator should not be used alone. Even John Bollinger himself highlighted that the indicator works best when paired with other tools like bandwidth, exponential moving average (EMA), and the Relative Strength Index (RSI). These additional indicators help confirm trends and improve the accuracy of signals.
Another important limitation is the use of the default setting, typically a 20-day simple moving average (SMA) and ±2 standard deviations. While commonly used, this setup is somewhat arbitrary and might not be suitable for every trading strategy or market condition. Traders are advised to adjust the SMA period and standard deviation based on their asset’s behavior and trading goals.
Conclusion
By analyzing the distance between the upper and lower bands, traders can identify potential buying or selling opportunities, especially when the price moves outside of these bands, indicating possible overbought or oversold conditions.
However, to achieve the best results, Bollinger Bands should not be used as a standalone signal. For a more reliable and well-rounded trading strategy, it’s important to combine this indicator with other technical analysis tools such as the Relative Strength Index (RSI), Stochastic Oscillator, and %B indicator.
Even John Bollinger, the creator of the indicator, has stated that like any other tool, the Bollinger Bands indicator should not be blindly trusted. Instead, it should be used as a part of a broader trading system to help you better understand price behavior, detect momentum shifts, and potentially improve your trading decisions.
Note: This article is part of the “Understanding the Crypto Trading Chart” series. More articles keep coming.
