July 28, 2024 Welcome back to our mini-series about advanced crypto trading strategies, where we try to master automated trading through technical analysis. In this blog post, we’ll continue to expand our toolkit with more advanced concepts that can boost the accuracy of our trading strategies.
But before we move forward, let’s briefly remind ourselves what we’ve covered during our journey.
In our first blog post of the series, we went through arguably the most basic measurement of technical analysis, the moving average (MA), and its different variations. Then, we learned how to establish entries and exits through MA crossovers, another fundamental concept of technical analysis.
Our second blog post covered two of the most famous technical indicators, the MACD and the RSI. We also learned more methods of establishing buy and sell signals, stop-loss, and take-profit goals, and how to improve the accuracy of our trading strategies by combining multiple indicators at a time.
In this blog post, we’ll continue expanding our technical analysis knowledge by reviewing yet another renewed technical indicator: the Bollinger Bands. As usual, we’ll discuss what it is, what it tells us, how to utilize it correctly, and how it fits everything else we’ve learned.
Before we begin, like all of our blog posts (specifically those focused on technical analysis), please remember that the information presented herein is intended for educational purposes only and should not be considered financial advice. Traders must consider their financial status, trading goals, and risk tolerance before employing any crypto trading strategy. Crypto trading involves inherited risks; consulting with a qualified financial advisor is highly recommended.
Now that we have it out of the way let’s go!
Bollinger Bands are traders’ most popular tools for measuring volatility and identifying overbought and oversold market levels.
Bollinger Bands consist of three lines, or bands, on the price chart. These lines constantly change as they move along with the market’s price changes.
The center line of the Bollinger Bands is a simple moving average (SMA). In a traditional setup, the SMA will be 20 periods long. While a period usually means days, it can also be shorter timeframes, like hours or even minutes, depending on the type of trading you’re focused on.
The two other lines that form the Bollinger bands are its borders. Technically, these borders are defined as two standard deviations from the middle band, either added to the price line (for the upper band) or subtracted from the price line (for the lower band).
In a professional setting, this classic setup of the Bollinger Bands is written as follows: Bollinger Bands (20,2), where the first number (20) refers to the length of the SMA, and the second number (2) refers to the number of standard variations being used.
To understand the logic behind the Bollinger Bands, it’s important to know what standard deviations are and what they mean. Generally, a standard deviation is the average distance of our data points from the average itself.
If that explanation wasn’t clear enough, we’ll try to simplify it through an example.
Let’s examine these numbers: 49 and 51 and 25 and 75.
If you calculate the average of each of these sets, you’ll get the same answer, which is 50. So, if we focus only on the average, we might come to the wrong conclusion that these two sets of numbers are the same, which is not the case. This is where standard deviation comes into play.
If we calculate the standard deviation of each set, we’ll find that while they both have the exact same average, the distribution of data around the average is quite different. Specifically, the 49-51 set has a standard variation of 1, while the 25-75 set has a standard variation of 25. Accordingly, we can argue that the higher the standard deviation value, the more volatile the traded asset is.
The Bollinger bands essentially form a price range by setting the top and bottom borders to two standard deviations from the middle band (the 20-period SMA). Based on the statistical rule that in normal data distributions, 95% of data points are expected to be contained within the range of two standard deviations, this measurement gives traders a relatively comprehensive overview of the market.
As a technical indicator based on pure statistics, Bollinger bands give traders a valid assessment of market volatility, an evaluation of current prices, and predictions about future price movements.
All indications derived from the Bollinger Bands are based on two statistical assumptions.
The first assumption is that 95% of prices should be constrained within the Bollinger Bands. In other words, we assume that prices are scattered in a normal distribution pattern.
The second assumption is that prices tend to revert to their long-term average levels in most cases. In the case of the Bollinger Bands, this concept, also known as mean reversion, means that prices are expected to tend to return to the middle band.
Now that we understand the underlying logic behind the Bollinger Bands let’s go through the main indications the Bollinger Bands give us traders about the market:
When prices are near the lower band’s level, the asset we are examining is undervalued. In most cases, these oversold conditions trigger buy signals since prices are expected to stay within the Bollinger Bands and return to their long-term average.
When prices fall below the support level of the lower band, this indicates a shift from current market conditions into a new bearish trend.
The upper band follows the same rules as the lower band, just in the opposite direction. The logic remains the same: only the upper band is now considered a resistance level that blocks prices from moving upwards and not a support level that keeps prices afloat.
Accordingly, when prices reach the upper band, they are currently overvalued. These overbought conditions trigger a sell signal, as we expect prices to come back down to their long-term average.
Like before, when prices break their normal distribution pattern, meaning they managed to break above the upper band, it alerts traders that a new bull market is probably about to begin.
The distance between the higher and lower bands gives traders a relatively accurate way to assess changes in volatility levels in the market and evaluate how volatile the market is now compared to the past.
Technically speaking, widening bands mean the standard variation’s value is growing, which means volatility is rising. Some experts interpret this as an indication that the general level of risk in the market is higher, which may imply working with tighter stop-losses.
Conversely, tightening bands mean the standard variation is declining, which indicates market volatility is in a downturn. When accompanied by lower trading volumes, this can indicate the evolution of a pattern called consolidation.
Consolidation, a pattern of lower volume and volatility levels, indicates a temporary balance between buying and selling in the market. It is often viewed as a reliable sign of a sideways trend in the market.
As we already covered, Bollinger Bands tries to establish overbought and oversold market conditions using a statistical calculation based on standard variations.
While this calculation method is fairly intuitive and reliable, similar to the advice we shared in our other blog posts of this series, it’s better to verify these signals with other technical indicators.
Specifically, this means that traders are highly advised to double-check their overvalued and undervalued signals with other technical indicators that measure the same thing in different ways, like the RSI or the MACD indicators we’ve covered in the past.
While each indicator has its merits, a buy or sell signal supported by more than one indicator should be much more accurate than a trading signal supported by only one indicator, powerful as it may be.
Now that we’ve covered buy and sell alerts let’s move forward to the specific case of tightening bands.
As we mentioned, the tightening of the Bollinger Bands strongly indicates a horizontal trend as the market consolidates in anticipation of the next big move. These indecisive moments are the perfect conditions for grid trading.
Bollinger Bands not only tells us when the market is suitable for grid trading but can also assist us in designing the actual grid itself.
While there are many different approaches, a classic way to set up a Bollinger Band grid is to use the different relationships between the lower, middle, and upper bands. For example, you can set up a long trade that enters a position when prices are around the lower band, with a take-profit goal around the middle or high band (and vice versa for a short position).
By doing so, traders are expected to have better risk management and overall results when deploying their grid setup into the markets.
Since technical analysis is the cornerstone of almost all types of active trading, a better understanding of technical indicators and chart patterns can only benefit your overall skills and, more importantly, your bottom line.
At Cornix, we believe strongly in combining strong analytical skills with even stronger automation. As such, we strive to offer our users everything they need to successfully implement this powerful combination in the market.
From fine-tuning pre-made trading strategies like Grid or DCA to designing your advanced strategy through our TradingView Bot, our platform offers a variety of easy-to-use trading tools designed to work under all market conditions.
Add to that a wide collection of educational resources, step-by-step video tutorials, and our two-week, no-strings-attached free trial, and nothing is stopping you from starting a new, exciting chapter in your crypto trading journey.
