The Bollinger Band is a technical analysis tool that was named after John Bollinger, a renowned technical trader. It is composed of three lines:
The chart above demonstrates the application of Bollinger Bands on the daily chart of BTC/USD traded at Coinbase. The upper band represents two standard deviations above the 20-period moving average, while the lower band represents two standard deviations below it. Standard deviation measures the difference between a group of values and the mean, making it a reliable indicator of volatility. When the bands expand, it indicates increased market volatility as prices move away from the lagging 20-period moving average. Conversely, when the bands contract, it suggests a decrease in market volatility.
Traders use Bollinger Bands to measure volatility and develop strategies based on them. There are two primary approaches:
In this strategy, traders wait for the market to approach the upper or lower bands before taking action. As the price gets closer to the bands, there is a higher possibility that the market is overbought (upper band) or oversold (lower band). Mean reversion traders execute a short position when the price touches the upper band and a long position when it touches the lower band.
Note: This strategy may not be suitable for highly volatile markets like Bitcoin or cryptocurrencies. Mean reversion is more appropriate for less volatile markets.
The second approach involves trading breakouts using Bollinger Bands. Traders execute a trade in the direction that the price breaches the band. If the price breaks above the top band, they enter a long position, and if it breaks below the lower band, they enter a short position. This strategy works best when the bands are narrowing, indicating that the market is preparing for a significant move.
A simple breakout strategy can be summarized as follows:
Note: It is recommended to use Bollinger Bands for breakout trades in Bitcoin or other cryptocurrencies due to their high volatility and tendency to trend for extended periods. Conduct thorough research before engaging in trading activities.
The formula to calculate Bollinger Bands is as follows:
Middle Band = MA[Source Price, n]
Upper Band = MA[Source Price, n] + (m * n-period standard deviation)
Lower Band = MA[Source Price, n] – (m * n-period standard deviation)
Where the source price can be open, high, low, close, etc. (chosen by the user)
n = number of periods (chosen by the user)
m = standard deviations (chosen by the user)
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