Trading is neither an exact science nor an art. It is a mixture of the two. There are many publicly available indicators, each of which claims to be the best. However, none of them are perfect or designed to be used alone.
One of the more popular indicators widely used by many traders is the Bollinger Bands, which can be used to spot price highs, lows, and opportunities to go short during a weak rally and buy during a sharp pullback.
Let us learn three simple ways to use this indicator in trading.
What is Bollinger Band?
John Bollinger created the Bollinger Band in the 1980s and owns the copyright. The indicator consists of a middle band, which is a simple moving average, its default setting is 20 periods, and the two outer bands are set at two standard deviations above and below the middle band.
Its most basic purpose is to determine whether the price is high or low on a relative basis. If the price is higher than the upper limit, the asset is considered overbought. On the other hand, if the price falls below the lower limit, the token is considered to be oversold.
However, many traders mistakenly assume that asset prices will fall when they reach the upper limit, or start to rebound when the price reaches the lower limit.
This usually only happens when the price stays within a range. As with any other indicator, assumptions can easily lead to huge losses in the trending market, so it is still a good practice to find converging points from multiple indicators.
Let’s look at several ways that traders use Bollinger Bands.
Bollinger Bands can find volatility squeeze
According to John Bollinger, assets switch between low volatility and high volatility phases. Therefore, after a period of low volatility, traders may expect volatility to soar, which may lead to trend fluctuations.
The above chart shows how the volatility of XRP dropped sharply between mid-September and mid-November 2020, marked as an ellipse on the chart. After about two months of low volatility, the volatility has soared, and the XRP/USDT currency pair provides excellent trading opportunities.
In the above example, Binance Coin (BNB) was in a downward trend from the end of September to mid-November 2018, and volatility tightened, which is marked as an ellipse on the chart. At this time, the volatility expanded to the downside, and the BNB/USDT currency pair resumed its downtrend.
The volatility squeeze does not predict the direction of the next breakthrough. Sometimes, market makers push prices above the upper limit and lower than the lower limit, which puts novice traders into trouble. Therefore, traders may avoid preemptive action and wait for the price to break below the resistance or support level before opening a position.
The above chart shows how over-eager bulls and bears get into trouble. On October 22, 2020, the bulls pushed the price to the upper limit, but failed to clear the resistance at $5.77. A few days later on November 3, 2020, the price fell below the lower limit, but did not break the USD 4.58 support level.
Ethereum Classic (and many more) Broke $5.77 on November 18, 2020, but this is not a perfect transaction because the price has not started a strong upward trend. Market makers started looking for buyers’ stop-loss points and tried to trap shorts in the sharp drop on December 23, 2020.
However, the price quickly rebounded above the lower limit on December 24, 2020, and the ETC/USDT currency pair soon began to rise strongly.
Therefore, traders should not only rely on Bollinger Bands signals, but also find confirmation from other supporting indicators or use support and resistance lines.
Bollinger Bands can issue a buy signal during a pullback
A pullback in an uptrend is usually a buying opportunity because the main trend tends to reappear. When the middle band is sloping upward and prices are trading in the area between the middle and upper bands, this is a sign of an uptrend. In this case, traders may wait for a rebound from the band to initiate a long position.
Litecoin (LTC) The chart shows the beginning of an uptrend in mid-February 2019, as the middle band appeared and prices traded between the middle and upper bands. After that, traders may try to buy a rebound from the mid-range and keep the stop loss below the swing low.
There are five possible market entry opportunities for conservative traders. Four of them will eventually become winners, but one will stop. This shows that no strategy is perfect, so stop losses should always be used to limit risk.
Solana (Sol) Fell from above the upper band on September 1, 2020, and fell below the middle band on September 3, 2020. Since then, the price has basically remained in the lower band, and will fall back on October 2, 2020. This confirms the downtrend and provides traders with an opportunity to go short on October 13, 2020, as the downtrend resumes after moving to the middle range.
Two Bollinger Bands can be used to track a strong uptrend
One of the most profitable trading methods is to buy and hold during a strong uptrend. However, this is easier said than done, because some traders sell prematurely out of fear, while others have been waiting for the decline.
This is where double Bollinger bands can come in handy. Kathy Lien, managing director of foreign exchange strategy at BK Asset Management, promoted its use.
To construct the settings, the trader uses the default values of the first Bollinger Bands. For the second Bollinger Bands, keep the value of the moving average at the 20-day SMA, but reduce the standard deviation of the outer band to 1.
As shown above, in an uptrend, the goal is to buy when the price is trading between the upper limit of the first and second Bollinger Bands.
There are several possible market entry opportunities. Traders will wait for the price to close in the high range for three consecutive days before buying, because this helps to avoid accidental washing.
Traders can keep the initial stop loss below the middle range, but quickly push it up to reduce risk and protect profits. One possible exit strategy is to sell when the market closes below the upper limit of the Bollinger Bands of one standard deviation.
The figure above shows how to use this strategy. Traders may enter the market on December 19, 2020, and keep trading until January 11, 2020 with a stop loss. Another buying opportunity appeared on February 7th, and finally stopped loss on February 23rd.
This strategy should be avoided when the price fluctuates within a range. In order to increase the odds, traders can only open new positions when the price breaks through the upper resistance.
Bollinger Bands can be a good tool to help traders identify trends early by discovering volatility squeeze, which is usually accompanied by the expansion of volatility and the trend phase.
Even if a trader misses an early buy, Bollinger Bands can also be used to join the trend with a low-risk entry opportunity during a pullback.
This indicator can also be used to trade during periods of strong trends with shallow corrections.
There are many ways to use Bollinger Bands, and this article only provides some guidelines that traders can explore.
The views and opinions expressed here only represent the views of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading action involves risk, and you should conduct your own research when making a decision.