A Guide to Trading Cryptocurrency Part 5: Bollinger Bands
Read Part 4 of BTCManager’s series, ‘A Guide to Trading Cryptocurrency,’ here. In Part 5, we move away from the East to the West, to an indicator named after a famous American author and financial analyst.
In this guide, you will be introduced to a strategy that is reliable and easy to use to trade and make money from cryptocurrencies like bitcoin, ether and others.
It is very interesting to observe trading veteran John Bollinger turn his focus to the most successful decentralized digital currency, bitcoin.
John Bollinger is the originator of the Bollinger Bands, an indicator that is used to confirm breakouts, indicate areas of support and resistance and to inform of highly profitable trades based on volatility in the market. The technique was introduced in the 1980’s, interestingly around the same time that Bill Williams developed his fractals trading method, both of which emphasize the dynamic nature of markets rather than the static nature characterized by many widely used trading indicators.
In Bollinger’s own words, the Bollinger Bands are described:
“So what are Bollinger Bands? They are curves drawn in and around the price structure usually consisting of a moving average (the middle band), an upper band, and a lower band that answer the question as to whether prices are high or low on a relative basis. Bollinger Bands work best when the middle band is chosen to reflect the intermediate-term trend, so that trend information is combined with relative price level data.”
When using the Bollinger Bands, we will see the price of the cryptocurrency or crypto-pair bracketed by an upper band, which indicates a relatively high price, and a lower band, which indicates a price zone that is relatively cheap. The middle bands acts like a simple moving average. When the market becomes more volatile, the bands widen whereas when volatility starts to settle, the bands contract.
There are a whole suite of indicators developed around the concept of Bollinger Bands, including the %b indicator, which acts like an oscillator, determining overbought and oversold conditions in the market.
The Bollinger Bands also act as dynamic support and resistance levels that change with the behaviour of the market, unlike traditional support and resistance levels, which are static.
Since mid-2016, Bollinger’s Twitter account has been analyzing and commentating on the price of bitcoin. With many financial commentators in the bitcoin space, John may provide a voice of reason for inexperienced traders and it is reassuring to Bitcoiners that he is bullish on the cryptocurrency.
So how can we use the Bollinger Bands to make cryptocurrency trades? There are two main strategies. The first is known as the Bollinger Squeeze, which we will detail below. Second, there is the Bollinger bounce.
The Bollinger Squeeze
The chart below shows the 4-hour price action for BTC-USD and illustrates how to use Bollinger Bands to get into a long position. When the bands contract, we wait for the breakout. On April 24, a bullish breakout signal was given, prompting an entry into a long position around $1252. In the following days, the signal was confirmed, as bitcoin continued higher above $1300. When we start to notice the bands contract again, we get ready to exit the long, as the squeeze could lead to a bearish breakout.
Hence, we look to exit around $1325, when the price is rejected from the resistance of the upper band and starts to test the support provided by the middle band/simple moving average.
While the market continued upward, we can use this strategy to make safe, profitable trades. We then wait for the next breakout, where on April 30, we obtained another bullish breakout, known as the Bollinger Squeeze. Therefore, we would have entered a long position around $1350. After that, we see the middle band display an upward gradient and we only exit once the price has tested the resistance provided by the upper band and the market returns to the middle band. This occurs around $1509 on May 5.
Now let us look at an example for a sell signal. Below the chart for ETH-USD is shown on the 4-hour timeframe. Notice that when the Bollinger Bands contract, a bearish breakout is confirmed as ETH-USD closed below the lower band, which foretold us of a large downward move.
Remember all three bands act as support or resistance, so when the market bounced upward and tested the middle band, we should have held onto our short position, as ether was pushed down from the middle band as it held as resistance.
Here is another example from the man himself. Back in May 2016, he accurately predicted a drop in BTC-USD before a large move to the upside. The same day of his tweet below, BTC-USD posted a fresh low around $435.03 before the “fake head” had been done and dusted, then bitcoin proceeded to rise, as he predicted, and ended up above $525 by the end of May.
It should also be mentioned that Bollinger Bands work well on any timeframe, but John Bollinger himself uses the one day timeframe as reference. Of course, using larger timeframes will open up moves with greater profit potential, but you also need greater patience than if you are trading short-term timeframes.
As mentioned previously, Bollinger Bands can be used to indicate dynamic support and resistance levels. The chart below shows the strategies you can use when the market is trendless. In this case, we buy when the market is near the lower band, or below it, and sell when the market price is near or above the upper bands. Notice that the bands are almost horizontal, suggesting the market has no direction and will continue to trade sideways.
However, it is important to remember there is no certainty with cryptocurrency and we should not trade too mechanically based on some predetermined rules.
Combining the Bollinger Bands with Other Indicators
Beginners should be aware that Bollinger Bands by itself will most likely not lead to profitable trades that you desire, you will get fake signals. Therefore, it is recommended that you use Bollinger Bands along with other indicators, for instance, the Relative Strength Index or %b to gauge sentiment and whether the crypto pair is overbought or oversold.
The chart below shows the 15 minute price action for LTC-USD and illustrates how to use Bollinger Bands in combination with an oscillator to determine when to exit a trade. Remember, the Bollinger Band gives good entry signals, prompting you to go long or short on a cryptocurrency, but it is not as good at letting you know when to take your profits and exit.
Notice around July 3, the Bollinger Bands were squeezing together and were horizontal, warning us of an imminent breakout. Then the Bollinger Squeeze signal is given, where a bullish breakout occurs when the 15 minute candle closes above the upper band at $40.50; immediately we should enter into a long position for LTC-USD. Notice at this point, the Relative Strength Index (RSI) is above 50, confirming that we should enter into a long.
How do we know when to exit? When the oscillator pushes deep into overbought territory, that is when the RSI is above 70, we look to exit the trade and take profits. Just an hour later after the signal was given, LTC-USD reaches a peak above $43 and the RSI peaks around 83, giving an indication to exit. However, the middle band is still trending higher, so depending on your risk appetite, you may want to wait a bit before closing the long.
LTC-USD then goes on to break above $45 and at this point the RSI becomes overbought again. Now, the middle band of the Bollinger bands stops trending upwards. The combination of these two signals give a strong signal to exit the long positions and take profit.
Alternatively, once entering the long around $40.50, we could take partial profit each time following this when the market enters the overbought zone.
As an another example, on July 7, LTC-USD displayed a bearish breakout, giving us an entry to go short around $48.60. The RSI goes into the oversold zone around $46.80, bounces higher then goes to a low of around $44. Notice that the RSI remains below 50 the entire time, and you can use this gauge to decide whether to stay in a trade or not. For example, when LTC-USD bounced higher from $46.80, many traders may have panicked and closed their shorts. However, the 50 threshold of the RSI can also be seen as a resistance (or support) and monitoring this oscillator, we would have held the short.
Notice that when LTC-USD completed a second leg down, the RSI entered into oversold territory again, prompting us to close out short positions and take profit.
Another indicator that can help identify and confirm signals given by the Bollinger Bands is the volume of the asset in question. For instance, the chart above shows a bullish breakout but the volume is very low, suggesting the upward movement will not sustain itself. Conversely, on the bearish breakout on July 7, this was supported by higher volume, suggesting the downward move will continue.
- The “Bollinger Squeeze” is a breakout signal that identifies the start of a new trend, useful for trending markets. The Bollinger Squeeze is characterized by low volatility, shown by the narrowing bands, and then a candle close above the Bollinger Bands as they start to expand again.
- For ranging markets, the “Bollinger Bounce” is a technique used to sell and buy cryptocurrencies. The Bollinger Bands are nearly horizontal and the upper and lower bands provide dynamic resistance and support respectively.
- The Bollinger Bands are not to be used alone; it is more effective to combine it with other indicators to identify exit points from a trade. Oscillator indicators and volume are complements to the Bollinger Bands.
- Look at the daily timeframe for profitable, high probability trades, but remember that patience is a virtue.
You can read the entire series of BTCManager’s ‘A Guide to Trading Cryptocurrency’ here.