Trading 101: Bollinger Bands

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BitStarz’s Trading 101 series opens the lid on the basic tools and signals you need to master in order to trade profitably. By using them together, and factoring in other indicators such as fundamental news, you can trade any asset or commodity, not just crypto.

What are Bollinger Bands?

Bollinger Bands display a range within which an asset is expected to move in the short term, derived by plotting two standard deviations (positive and negative) away from the moving average (MA). They were created by noted financial analyst John Bollinger in the 1980s and are still very popular.

Many traders believe that as prices move to the upper band they represent an overbought market, while prices that move more towards the lower band represent an oversold market. John Bollinger has a set of 22 rules to follow when using the bands, which you should read if you intend to use Bollinger Bands as
a technique.

What Do Bollinger Bands Tell Us?

The below chart shows Bollinger Bands based off a 20-day MA. Despite being a retrospective tool, as we can see it nevertheless paints a fairly accurate picture of where the short term price bottoms out and tops out, allowing traders to make fairly accurate predictions of where they should buy and sell.

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The Squeeze

The squeeze is a core principle of Bollinger Bands, and occurs where the bands move closer together for a period. A squeeze signals a period of low volatility and is considered to be a potential sign of future increased volatility and possible trading opportunities.

A squeeze can be seen in the above chart around May 29, which preceded a spell of volatility, although the bands give no indication when the change may take place or which direction price could move. The further apart the bands are, the more likely the chance of a decrease in volatility, which would suggest a good exit point for a trade.

Breakouts

Approximately 90% of price action occurs between the two Bollinger Bands, meaning that any breakout above or below is a major event. A breakout is not a trading signal however, and a common mistake new traders make is thinking that price hitting or exceeding one of the bands is a signal to enter or exit a position. Breakouts offer no clue as to the direction or extent of future price movement. This can be seen at 13:00 on May 29 when the price spiked out of the bands and then fell back again.

Limitations of Bollinger Bands

Like any trading tool, Bollinger Bands are not perfect and should not be used in isolation. John Bollinger recommends using them in association with two or three other indicators that provide more direct market signals, ideally ones that use different types of data. Good examples of this are moving average divergence/convergence (MACD), volume, and relative strength index (RSI).

Squeeze, Volume, Action!

Bollinger Bands can be a great indicator of when an asset is likely to move, and can offer some idea of the direction of the move, but factoring in other indicators is crucial to establish likely direction. Just remember that when the bands squeeze together is when to expect action.

Keep an eye out for the next edition of our Trading 101 series.

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