The wild zigzags of a typical cryptocurrency price chart can look bewildering at first glance. It’s easy to see the general direction of a given crypto – either up or down – but the confusion really sets in when you zoom in and take a look at all the little peaks and troughs that make up that general trend line.
It’s no different in traditional securities, where this issue has been addressed by creating moving averages. Simple moving averages describe the average price of a security over a period of time, while exponential moving averages give more credence and arithmetic weight to newer prices. Both are intended to filter out the daily or hourly bumps that make up a typical price chart, making trends and patterns more immediately obvious.
This system was further refined in the 1980s by financial analyst and author John Bollinger with his introduction of Bollinger bands. Bollinger bands are a system of computing high and low bands above a security’s moving average using standard deviation.
Prior to John Bollinger’s work, high- and low-price bands were created around moving averages using a technique developed by Chester Keltner in 1960 called Keltner channels. Keltner himself relied upon work done by J. Welles Wilder for computing average true ranges for measuring volatility in commodity markets.
Keltner channels mark bands above and below moving averages using average true range as a guide. Average true range is an indicator of pure volatility rather than future direction. Keltner channels build upon this tool to present a way to visualize potentially overbought or oversold securities. Prices that break the channel’s upper boundary signal a coming bull rush. Likewise, prices that dip below the lower boundary indicate that a bear market is on the way.
Bollinger bands utilize standard deviation rather than average true range, a more volatile measurement that creates a more jagged band channel. This channel, however, is more adaptive than a Keltner channel precisely due to its increased volatility, and it ultimately creates a more consistently spaced channel around the moving average.
John Bollinger, Image from YouTube
Bollinger bands can also be used to examine exponential moving averages as opposed to the Keltner channel’s simple moving averages. This provides the measurement tool with a higher degree of sensitivity to changes in the market.
In the notoriously fickle cryptocurrency market, Bollinger bands are seeing widespread use in predicting possible breakouts and identifying key times to enter and exit the market. This is particularly useful for day traders, who often have to make tough calls with incomplete information in order to retain their profits. One significant step in the wrong direction on a single coin can eliminate days or weeks of carefully harvested small gains.
The Basic Rules
The first thing Bollinger makes clear is that highs and lows are relative. The upper band signifies highs as they relate to the standard deviation, while the lower band presents the converse of this. This relative use of the terms “high” and “low” can be used to derive a variety of different indicators upon which to base price decisions.
Bollinger Bands, Image from Wikipedia
It is vital, however, that each indicator be viewed in isolation. Momentum, volume, sentiment, and more may all be derived from Bollinger bands, but they might not necessarily be related to one another.
“For example, a momentum indicator might complement a volume indicator successfully, but two momentum indicators aren’t better than one,” Bollinger wrote.
Bollinger bands can be successfully employed in a wide range of financial settings due to their rather simple nature. Bollinger himself said they are appropriate for equities, indices, exchanges, commodities, and futures. Cryptocurrencies, while not explicitly named, are assumed fit between the gray areas of these varied financial tools.
The bands are also flexible with regard to time, as long as the time period being examined contains enough granular details to present a meaningful snapshot of the market.
However, the key word here is snapshot.
“Bollinger bands do not provide continuous advice; rather they help identify setups where the odds may be in your favor,” Bollinger wrote. “Make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The distribution of security prices is non-normal and the typical sample size in most deployments of Bollinger bands is too small for statistical significance. (In practice we typically find 90%, not 95%, of the data inside Bollinger bands with the default parameters).”
How to Use Them
Cryptocurrency traders and investors employing Bollinger bands can use them in several different ways.
The first useful piece of advice that can be gleaned from Bollinger bands is the volatility of a given coin. Bollinger bands compress or squeeze when standard deviations are low, signaling a period of low volatility. They tend to expand when volatility increases, as the standard deviations used in their calculation likewise increase.
Bollinger Bands showing period of low volatility, Image from Cryptovest
This can have several different meanings depending on the coin in question. The very fact that volatility is increasing or decreasing, however, might point to investment opportunities or an upcoming breakout – up or down – in the price.
Bollinger bands capture around 90 percent of the price action in a given security or coin. When price movements dive above or below a set Bollinger band, it’s time to sit up and pay attention. When the price “tags” above the band, it means that the coin is likely overbought and liable to correct shortly. This presents an ideal time to sell before prices almost inevitably fall.
If, on the other hand, a price tags at or below the lower Bollinger band, the coin is oversold, and smart traders should probably view this as an ideal time to buy in.
Movements at the Bollinger band boundaries can also be used to interpret near-term price direction. If the upper band is cracked, and then the price corrects to a level just at or below the upper band, it’s a sign that prices are generally moving up. The opposite is true on the lower band. Prices that dip below the band but fail to correct much above the band level are headed down.
Bollinger bands present an easy-to-visualize method of looking at the cryptocurrency market. In simplest terms, it’s a good idea to buy when your coin’s price is between the moving average and the bottom of the band. It’s a good time to sell when your coin is between the moving average and the top band. If your coin happens to shoot above or slide below those bands, it might be the best possible time to make a move.
However, Bollinger bands are just one of the many tools in a trader’s toolkit, so the rules are not written in stone. There might be great opportunities to buy or sell in opposition to the technical analysis provided by the Bollinger band. To confirm their findings using Bollinger bands, many traders rely on volume indicators or the relative strength index before placing their bets, so to speak. Independently confirming trends seen within the Bollinger band system is more reliable than taking the system’s findings in isolation. Remember, even John Bollinger pointed out that Bollinger bands cannot provide continuous advice, and they are by nature a lagging indicator due to their use of standard deviations from a moving average.