Trade the Charts: Bollinger Bands

Posted by Josh Blatchford | Education

Bitcoin has backed off the $5000 high from late August/early September. For traders, this means getting back to the business of implementing winning trading strategies for varying market conditions. In our Trade the Charts series, now that we’ve covered Moving Averages, we are going to look at a moving average based indicator: Bollinger Bands.

Who is John Bollinger?

John Bollinger, the creator of the Bollinger Bands in the 1980’s, is a technical analysis based trader who developed this tool for pattern recognition in determining relative highs and lows on trading charts.

In other words, when a chart isn’t showing a new high or a new low, there are still spots where there is a relative high or relative low, as it relates to recent price activity. Spotting new highs and lows is pretty easy on a chart but relative highs are a little more of a challenge.

Let’s see what they are and how they work.

What Are They?

Bollinger Bands start with a moving average. The most common in most charting software is 20 periods, which could mean hours for forex or Bitcoin or days for stock. A Bollinger Band chart will always have a moving average on it. Simple moving averages are the standard although some will use exponential moving averages.

Once we have the moving average, we have to create the bands themselves. We create the bands with one of the most common statistics: Standard Deviation. Standard Deviation measures a set of data points (prices) to gauge how much variation there is between values. Here’s a simple example:

For stock prices between $5 and $15 per share, we have 2 sets of prices over 5 days:

  • 5, 8, 10, 12, 15
  • 5, 12,16, 18, 15

In this example, you can see just by the numbers that there is more variation in the 2nd set than the first. Calculating Standard Deviation, which is easy in Excel or Google Sheets with the preloaded formula, proves this out where the first set has a std deviation of 3.80 while the 2nd set has a std deviation of 5.06, meaning the numbers are closer to the average in the first set.

With Bollinger Bands, the common standard deviation used is 2 standard deviations from the moving average. Two standard deviations are important, as those who’ve taken a Statistics class may remember, incorporates 95% of all values when they are drawn as a bell curve (normal distribution). This 95% is known as a confidence interval or confidence level. This is what a graph of 2 std deviations and a moving average looks like on a chart.

This chart, courtesy of Wikipedia, shows the moving average in blue and the Bollinger Bands with the upper band in Red and the lower band in Green. It’s a 20 day moving average with 2 standard deviations for the S&P 500.

The Importance of Volatility

Bollinger Bands are a blending of moving averages (the blue) with volatility (the red and green). Since all are drawn as lines on the chart, you get a visual representation of when there is more volatility.  Between 10/8 and 11/8 on the chart where the space between the red and green lines is much wider than on 1/9 where the gap is much narrower.

Those spaces between the bands are visual measures of volatility in the S&P.

How Do Traders Use the Bands

There are many different methods people use to trade using Bollinger Bands. Let’s look at some examples.

  • Volatility/Options Traders: Options traders trade on volatility more than other traders since an option and its underlying stock’s volatility is a big factor in the option’s price. Volatility and Time to expiration are the primary factors in an option’s price. In the January period on the S&P chart above, that narrower gap in volatility means volatility is relatively low, meaning options traders should BUY options. They can buy put options, call options or both and can make money on an increase in volatility to the average even if the underlying stock moves against them.  Bands are a great tool for volatility traders.

Can you do this with Bitcoin’s volatility? You can if you have a margin account, use leverage and/or have multiple accounts with one as a long account and one as a short account.

  • Trend following traders: Many traders use some form of trend following technique. These traders will use the bands to trade when price moves outside them, meaning if a stock or a cryptocurrency moves above the upper band, then they take that as a buying signal. Conversely, a price breaking down below the lower band would trigger a selling or shorting signal.

 

  • Short-Term traders: A common short-term trading strategy with the bands is to trade the range from a band up to or down to the moving average. Since we have 3 lines on our chart, the moving average and the bands, this would be a simple strategy to follow and trade to go long from the lower band up to the moving average or go short from the upper band down to the moving average.

 

  • Moving Average traders: Many traders do moving average crossover trading. As we discussed in our Moving Average post, that means using 2 averages like the 20-day and the 50-day averages and when the 20 crosses the 50 it’s a buying signal. A crossover trader can trade with some confidence using Bollinger Bands that show 95% of likely values. The bands help traders determine if the crossover is a good buying signal or not by checking how much room is in the upper band (on the buy) or lower band (on the sell).

 

TradingSim shows some great strategies for how to trade Bollinger Bands.

Bitcoin and Its Volatility

You don’t need us to tell you that Bitcoin’s been volatile recently. All these crazy price movements do that for you. Let’s check out a Bitcoin chart with Bollinger bands on them.

This chart from BitcoinCharts.com shows us 3 months of Bitcoin pricing on Bitstamp. One great thing they do for Bollinger Bands is they highlight the space between the bands in blue. Most of August, you see the space in the bands is pretty wide and it gets narrower through September until the recent price drop.

The line on the bottom chart is another helpful tool when using Bollinger Bands, Bollinger Band Width. This line shows if the width of the bands is growing or shrinking, a great way to look at volatility. This chart is telling us we may be entering a high volatility period in Bitcoin trading.

Conclusion

Bollinger Bands are a great trading tool. Bitcoin traders can use it, along with another tool of your choice to determine:

  • Bitcoin’s volatility
  • Bitcoin’s relative high or low
  • If Bitcoin is trending or non-trending
  • A view of 95% of all prices in a given period with the bands
  • Good support and resistance points (at the low band for support and upper for resistance) for your trades

Like all good trading tools, you cannot and should not use it alone in a vacuum. You should be using multiple signals for confirmation of a trend or a reversal so you can fight off false signals and the losses they generate. Bollinger bands are a tool you should consider adding to your trading arsenal.

Tell us on Twitter @Magnr which tools you like and why? We’d love to hear from you.