Good day everybody,
Welcome to CryptoGod-1's blog on all things crypto. Today we are going to continue the series on Technical Analysis (TA) and why it can be such an important asset for new or experienced traders. In this series I am covering some of the different Technical Analysis and Indicators which can be used to help determine market movement and sentiment when trading. For Part III the focus will be on Bollinger Bands (BB).
Bollinger Bands (BB)
Developed by John Bollinger and named after him, the Bollinger Bands are a set of trendlines plotted two standard deviations, one being positive and one being negative, separated with a simple moving average. They were developed and copyrighted by the famous technical trader John Bollinger, who designed them to help in discovering opportunities that give investors a higher probability of identifying when an asset is oversold or overbought correctly. The three lines used for the BB are very important, with the upper and lower lines referred to as the upper and lower bands. They are placed directly on the candle chart, and users read them in tandem with the changing prices and candlesticks.
Calculating a BB
To calculate the BB requires a trader to figure out the simple moving average of the asset in question, generally making use of a 20 SMA. This would take into account the closing prices of the previous 20 candles and make an average price of them. Once a trader has calculated the SMA, the next step in the process is finding out the standard deviation of the assets price over the same period, i.e. 20. Standard deviation is a mathematical measurement of average variance and features prominently in statistics, economics, accounting, and finance. The standard deviation is calculated by taking the square root of the variance, which is the average of the squared differences of the mean. After that, a trader should multiply the standard deviation value by two. To get the value for the upper band a trader should add the standard deviation to the moving average. For the lower band, simply subtract the standard deviation from the moving average.
Some of the most common values used in calculating the BB are:
Short term: 10 day moving average, bands at 1.5 standard deviations. (1.5 times the standard dev. +/- the SMA)
Medium term: 20 day moving average, bands at 2 standard deviations.
Long term: 50 day moving average, bands at 2.5 standard deviations.
How to use a BB
The BB is a very popular tool when it comes to TA, as many traders use it to establish a range for the price to move between. Often traders will follow the rules of the closer the price of an asset moves towards the upper band, the more overbought an asset is. The opposite is true when the price moves towards the lower band, as it is believed the more oversold an asset is on the market. This is because the price will often consolidate and move back towards the centre of the band, although it is not always certain as sometimes the price can continue to fall or rise when close to the lower and upper bands respectfully.
The bands widen when the market is more volatile, giving a wider spread of price and indicating a large change of price action is occurring. This can also be an indicator that the existing trend is ending as the bands widen. When the bands tighten, this generally indicates a period of low volatility. This can signal the beginning or a range or a trend in the market. A trending move can sometimes be a false move as the price will often bounce between the upper and lower band, especially once they have tightened. This can result in a sudden change in direction, which is why traders need to be aware of these levels when trading. The bouncing can also be excellent for price targets, for example if the price bounces off the lower band, then crosses the moving average, the upper band should be the profit target.
There will be times when the price hugs and climbs up or down along the upper or lower band line for a prolonged period of time. This often happens during strong trending periods. This can lead to increased profits if a trader uses the BB along with other TA, for example an RSI. When the price moves outside the bands, it is often an indicator that a strong trend continuation of price movement is to be expected. Once the price moves back inside the band, then the suggested strength is negated and often a reversal is to be expected.
Two strong terms associated with BB are 'The Squeeze' and 'Breakouts'. The Squeeze is as mentioned above when the bands come together and signals a low period of volatility. Traders take this as a signal of a sign that future increased volatility is possible along with trading opportunities. Some traders like to trade in this period of low volatility, taking lower profits while the price swings between the bands. Once the bands widen, the greater the opportunity of taking increased profits. However, the bands are not trading signals and the price can break beyond the bands at any time once increased volatility occurs. While 90% of price action happens within the bands, when the price breaks byond the upper or lower band it is known as the breakout. As mentioned above this is a major event in terms of a change in volatility in the price action, but should not be taken as a trading signal. The breakout will provide no information as to the future direction of the price and often traders make the mistake in taking the breakout as a signal to buy or sell.
Below are example's of how the BB works on the 15 minute and 4 hour ETH charts.
As you can see in the 15 minute chart above the BB lines, indicated in white, narrow when the volatility of the price is minimal and widen when the volatility is high. The price also moves from the lower band to the upper band which crossing the average, especially doing the bounce movement while in the lower band width. The wider band withs happen when the breakout occurs, as the price is dropping before moving back within the bands. Once it moves back within the bands the dropping trend has stopped, with a short period of range occurring before another large drop happened with another breakout. Once the price moved back into the bands from the second breakout it proceeded to climb towards the moving average as the width of the bands narrowed.
On the 4 hour chart traders can see how the hugged and climbed along the upper band over a prolonged period of time. This happened as part of multiple breakout, before correcting by reducing back towards the average price. The bands narrowed as the price stopped hugging and climbing the upper band, and bounced off the lower band when it hit it. Once the price moved back above the average it hugged the upper band again, while the upper band widened. The bands themselves never indicated which direction the price would move, yet they clearly show how the price was with low and high volatility. Combining EMA or RSI along with the BB can help to improve the analysis even further.
Limitations of a BB
When trading, using BB along is not sufficient for a trading system. They are purely an indicator in relation to price volatility, and should be used along with two or three other non-correlated indicators that provide more direct market signals according to its creator John Bollinger. Through combining it with other types of data such as moving averages and volume, traders wont be relying on the data from BB alone. This data is created from a simple moving average, which weights older price data similar to more recent ones. The problem with this, as with most TA, is that the new information may be diluted by outdated data. Along with this, the fact the data is created from the SMA with a two standard deviation, the data may become arbitrary and may not work for everyone in every situation. Therefore it is important for Traders to adjust their SMA and standard deviation assumptions accordingly.
Conclusion on using a BB for TA
As a trader, whether it be day trading or long term trading, using the BB can be very beneficial in understanding what levels the price is fluctuating between. The BB should never be taken as a trading signal, although it can help to determine where to price is fluctuating between. When the bands narrow it points to a period of low volatility, while the bands extending point to high volatility. When the price does extend beyond the bands it can be a breakout, which in itself does not indicate where the future price will go, but often signals a potential change in the trend of price movement.
As stated whether you are experienced or new, Technical Analysis can always be a useful asset when trading. Just remember it is not guaranteed and nobody can predict the future, no matter how certain you believe the patterns to be. It is always just another tool of the trade to help make more informed decisions when trading. It can be easy to fall into the trap of thinking if the price hits the upper band it will soon drop, and the opposite when it hits the lower band. It is important to use BB along with other TA to get the correct signals for buying and selling, using the BB to help narrow where you believe the price will be and where your profit targets should be. Always zoom out, if trading on a 15 minute chart check the 1 hour or 4 hour or even 1 day chart to give you a better idea of the overall trend direction and the extent and width of the BB.
You can find the previous parts to the series here:
Technical Analysis - Part I - Exponential Moving Average (EMA)
Technical Analysis - Part II - Relative Strength Index (RSI)
I hope this post was beneficial and of some use, and I plan on continuing the series with the next instalment focusing on Moving Average Convergence Divergence (MACD). Of course each technical analysis provides different beneficial information, so combining your most trusted and favourite ones can be the best strategy for finding entry and exit points when trading.
Have a great day.
Peace. CryptoGod-1.
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