Is Bitcoin Overbought or Oversold? Use Bollinger Bands to find out!

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Trading is neither an exact science nor an art. It’s a mix of both. There are numerous publicly available indicators and each one claims to be the best. However, none of them are perfect or designed to be used in isolation.

One of the most popular indicators widely used by several traders is Bollinger Bands, an indicator that can be used to identify price spikes, lows, and short selling opportunities during exhausted rallies and buying during sharp setbacks.

Let’s learn three simple methods to use this indicator in trading.

What are Bollinger Bands?

John Bollinger created and copyrighted the Bollinger Bands in the 1980s. The indicator consists of a middle band, which is a simple moving average, the default of which is set to 20 periods, and two outer bands that are set to two standard deviations below and above the middle band.

BTC / USDT daily chart. Source: TradingView

Its most basic use is to determine whether the price is high or low on a relative basis. If the price is above the upper band, the asset is perceived as overbought. On the other hand, if the price drops below the lower band, the coin is believed to be oversold.

However, many traders make the mistake of assuming that asset prices will fall when it hits the upper band or that a rally will begin when the price hits the lower band.

This generally only happens when the price is stuck in a range. As with any other indicator, assumptions can easily lead to huge losses in a trending market, so looking for the confluence of a number of metrics is still a good method.

Let’s look at some of the ways traders use the Bollinger Bands.

Bollinger Bands can detect volatility bottlenecks

According to John Bollinger, assets alternate between periods of low volatility and high volatility. Therefore, after periods of low volatility, traders can expect an increase in volatility, which could lead to trend movements.

XRP / USDT daily chart. Source: TradingView

The above chart shows how the volatility of XRP dropped sharply between mid-September and mid-November 2020, marked as an ellipse on the chart. After about two months of this low volatility period, volatility skyrocketed and the XRP / USDT pair provided an excellent trading opportunity.

BNB / USDT daily chart. Source: TradingView

In the example above, Binance Coin (BNB) was in a downtrend and volatility intensified between late September and mid-November 2018, marked as an ellipse on the chart. Here volatility expanded on the downside and the BNB / USDT pair continued its downtrend.

A volatility squeeze does not predict the direction of the next breakout. Sometimes the market makers push the price above the upper band and below the lower band, trapping the beginners. Therefore, traders can avoid anticipating direction and wait for the price to break either above the resistance or below the support of the range before entering a position.

ETC / USDT daily chart. Source: TradingView

The graph above shows how the overzealous bulls and bears can get trapped. On October 22, 2020, the bulls pushed the price above the upper band but failed to break the resistance at $ 5.77. After a few days on November 3, 2020, the price pulled below the lower band but did not break the $ 4.58 support.

Ethereum Classic (ETC) broke above $ 5.77 on November 18, 2020, but it wasn’t a perfect trade as the price didn’t trigger a strong uptrend. The market makers went on the hunt for buyer stops and also tried to catch the bears with the sharp decline on December 23, 2020.

However, on December 24, 2020, the price quickly climbed back above the lower band and the ETC / USDT pair soon began a strong upward move.

Therefore, rather than relying solely on the signal from the Bollinger Bands, traders should also look for confirmation from other supportive indicators or use the support and resistance levels.

Bollinger bands can signal when to buy during a pullback

A pullback on an uptrend is usually a buying opportunity as the main trend tends to reassert itself. If the middle band is rising and the price is trading in the area between the middle band and the upper band, it is a sign of an upward trend. In this scenario, traders can wait for the mid-band to rebound in order to open long positions.

LTC / USDT daily chart. Source: TradingView

Litecoin (LTC) chart shows the start of an uptrend in mid-February 2019 when the middle band appeared and the price traded between the middle and upper bands. After that, traders can try to buy the mid-band rebound and keep the stop loss just below the swing low.

There were five possible entry options for a conservative trader. Four of them turned out to be winners, but one would have made the stops. This shows that no strategy is perfect, so a stop loss should always be used to limit risk.

SOL / USDT daily chart. Source: TradingView

Solana (SOL) turned down from above the upper band on September 1, 2020 and broke below the middle band on September 3, 2020. Since then, the price has remained largely within the lower band, which went down on October 2, 2020. This confirmed the downtrend and offered traders the opportunity to sell short on October 13, 2020 as the downtrend returned after moving to the middle band has been recorded.

Two Bollinger Bands can be used to track strong uptrends

One of the most profitable trading methods is to buy and hold during strong uptrends. However, this is easier said than done as some traders sell too early out of fear and others keep waiting for the dip.

The double Bollinger bands can be used here. Its use was made known by Kathy Lien, FX Strategy General Manager at BK Asset Management.

To build the setup, traders use the default value for the first few Bollinger Bands. For the second Bollinger Bands, keep the value of the moving averages at the 20-day SMA, but reduce the value of the standard deviation of the outer bands to 1.

BTC / USDT daily chart. Source: TradingView

As shown above, in an uptrend, the goal is to buy when the price is trading between the upper band of the first and second Bollinger bands.

Multiple entry options are possible and a trader would wait three consecutive days for the price to close between the upper bands before buying, as this can help avoid unexpected swings.

Traders can keep the initial stop loss below the middle band but pull it up quickly to reduce risk and protect profits. One of the possible exit strategies would be to sell with a standard deviation on a closing price below the upper band of the Bollinger Bands.

The graphic above shows how the strategy is used. Traders may have got in on December 19, 2020 and stayed in trading until the stops were hit on January 11, 2020. Another buying opportunity arose on February 7th, which finally hit the stops on February 23rd.

This strategy should be avoided when the price is fluctuating in a range, and to improve the odds, traders may only open new positions when the price breaks out of stiff overhead resistance.

The central theses

The Bollinger Bands can be a good tool to help traders spot a trend early by identifying the volatility pressures that are usually followed by a volatility expansion and trending phase.

Even if a trader missed the buy prematurely, the Bollinger Bands can be used to enter the trend on pullbacks with a low risk entry point.

The indicator can also be useful for trading during a strong trend phase when the corrections are flat.

There are many different ways you can use the Bollinger Bands, and this article provides just a few guidelines for traders to explore.

The views and opinions expressed are those of the author only and do not necessarily reflect the views of Cointelegraph.com. Every step of investing and trading involves risk, so you should do your own research when making a decision.