Is Bitcoin overbought or oversold? Use Bollinger Bands to find out!

Trading is neither an exact science nor art. It is a mixture of both. There are scores of publicly available indicators and each claims to be the best. However, none of them are perfect or designed to be used in isolation.

One of the more popular indicators widely used by several traders is Bollinger Bands, an indicator that can be used to spot price peaks, lows, and opportunities for shorting during exhausted rallies and buying during sharp pullbacks.

Let’s learn three simple methods to use this indicator in trading.

What are Bollinger Bands?

John Bollinger created and copyrighted the Bollinger Bands in the 1980s. The indicator consists of a middle band, which is a simple moving average whose default is set at 20-periods and two outer bands set at two standard deviations below and above the middle band.

Its most basic use is to identify whether the price is high or low on a relative basis. If the price is above the upper band, the asset is perceived to be overbought. On the other hand, if the price dips below the lower band, the coin is believed to be oversold.

However, many traders make the mistake of assuming that the asset price will drop when it reaches the upper band, or that a rally will start when the price hits the lower band.

This generally happens only when the price is stuck in a range. As with any other indicator, assumptions can easily lead to huge losses in a trending market so looking for confluence from a number of metrics is still a good pratice to employ.

Let’s look at a few ways traders use the Bollinger Bands.

Bollinger Bands can spot volatility squeezes

According to John Bollinger, assets switch between phases of low volatility and high volatility. Therefore, after periods of low volatility, traders may expect the volatility to shoot up, which could result in trending moves.

The above chart shows how XRP’s volatility dropped sharply between mid-September to mid-November 2020, marked as an ellipse on the chart. After about two months of this low volatile phase, the volatility shot up and the XRP/USDT pair offered an excellent trading opportunity.

In the above example, Binance Coin (BNB) was in a downtrend and the volatility tightened between the end-September to mid-November 2018, marked as an ellipse on the chart. Here, the volatility expanded to the downside and the BNB/USDT pair resumed its downtrend.

A volatility squeeze does not predict the direction of the next breakout. Sometimes, the market makers nudge the price above the upper band and below the lower band, trapping the novice traders. Therefore, traders may avoid pre-empting the direction and wait for the price to either break above the resistance or below the support of the range before establishing a position.

The above chart shows how the overly eager bulls and bears can become trapped. On Oct. 22, 2020, the bulls pushed the price above the upper band but could not clear the resistance at $5.77. After a few days on Nov. 3, 2020, the price pulled below the lower band but did not break the support at $4.58.

Ethereum Classic (ETC) broke above $5.77 on Nov. 18, 2020, but it was not a perfect trade as the price did not start a strong uptrend. The market makers went hunting for buyers’ stops and also tried to trap the bears with the sharp drop on Dec. 23, 2020.

However, the price quickly climbed back above the lower band on Dec. 24, 2020, and the ETC/USDT pair soon started a strong up-move.

Therefore, instead of relying only on the signal from the Bollinger Bands, traders should also look for confirmation from other supportive indicators or use the support and resistance lines.

Bollinger Bands can signal when to buy during a pullback

A pullback in an uptrend is usually a buying opportunity as the main trend tends to reassert itself. When the middle band slopes up and the price trades in the area between the middle band and the upper band, it is a sign of an uptrend. In this scenario, traders may wait for the bounce off the middle band to initiate long positions.

Litecoin’s (LTC) chart shows the start of an uptrend in mid-February 2019 as the middle band turned up and the price traded between the middle band and the upper band. After that happens, traders may attempt to buy the rebound off the middle band and keep the stop-loss just below the swing low.

There were five possible entry opportunities for a conservative trader. Four of them turned out to be winners but one would have hit the stops. This shows how no strategy is perfect, hence a stop-loss should always be used to limit the risk.

Solana (SOL) turned down from above the upper band on Sep. 1, 2020, and broke below the middle band on Sep. 3, 2020. Since then, the price largely remained inside the lower band, which turned down on Oct. 2, 2020. That confirmed the downtrend and gave an opportunity to traders to short on Oct. 13, 2020, as the downtrend resumed, following a move to the middle band.

Two Bollinger Bands can be used to track strong uptrends

One of the most profitable ways to trade is to buy and hold during strong uptrends. However, this is easier said than done because several traders sell too early out of fear and others keep waiting for the dip.

This is where the double Bollinger Bands can come in handy. Its use has been popularized by Kathy Lien, the managing director of FX Strategy for BK Asset Management.

To construct the setup, traders use the default value for the first Bollinger Bands. For the second Bollinger Bands, keep the value of the moving averages the same at 20-day SMA but reduce the value of the standard deviation of the outer bands to 1.

As shown above, in an uptrend, the aim is to buy when the price trades between the upper band of the first and second Bollinger Bands.

There are several entry opportunities possible and a trader would wait for the price to close between the upper bands for three successive days before buying because this can help to avoid unexpected whipsaws.

Traders can keep the initial stop-loss below the middle band but quickly trail it higher to reduce the risk and protect profits. One of the possible exit strategies would be to sell on a close below the upper band of the Bollinger Bands with one standard deviation.

The chart above shows how the strategy is used. Traders may have entered on Dec. 19, 2020, and remained in the trade until the stops hit on Jan. 11, 2020. Another buying opportunity arose on Feb. 7, which finally hit the stops on Feb. 23.

This strategy should be avoided when the price is oscillating in a range and to improve the odds, traders could only open new positions when the price breaks out of a stiff overhead resistance.

Key takeaways

The Bollinger Bands can be a good tool to aid traders in identifying a trend early by spotting the volatility squeeze, which is usually followed by an expansion in volatility and a trending phase.

Even if a trader missed buying early, the Bollinger Bands can be used to join the trend during pullbacks with a low-risk entry opportunity.

The indicator can also come in handy for trading a strong trending phase where corrections are shallow.

There are many different ways to use the Bollinger Bands and this article just provided a few guidelines that traders can explore.

The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should conduct your own research when making a decision.