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Bollinger Band: a key indicator shows when cryptocurrencies are oversold or overbought

What Is a Bollinger Band?

A Bollinger Band is a technical analysis tool defined by a set of trend lines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of a security's price, but which can be adjusted to user preferences. Bollinger Bands was designed to discover opportunities that give crypto investors a higher probability of properly identifying when a cryptocurrency such as Bitcoin (BTC) and Ethereum (ETH) is oversold or overbought.

Understanding Bollinger Band

1. How To Calculate Bollinger Bands

The initial phase in figuring Bollinger Bands is to compute the simple moving average of the security in question, commonly utilizing a 20-day SMA.

2. What Does Bollinger Bands Tell You?

Bollinger Bands are a highly popular technique indicator of crypto market. Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market.

In the chart depicted below, Bollinger Bands bracket the 10-day SMA of the cryptocurrency with an upper and lower band along with the daily movements of the market's price. Because standard deviation is a measure of volatility, when the markets become more volatile the bands widen; during less volatile periods, the bands narrow.

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3. The Squeeze

The squeeze is the central concept of Bollinger Bands. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities. Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or which direction price could move.

4. Breakouts

Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is a major event and worth to get trader's attention. The breakout is not a trading signal. The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement.

How to Use Bollinger Bands

That's the question every crypto investor wants to know. The upper and lower bands measure volatility, or the degree in variation of prices over time. Because Bollinger Bands measure volatility, the bands adjust automatically to changing market conditions.

The bands tend to narrow when an index goes quiet and price changes are small. At other times, the bands widen as price becomes volatile and changes get bigger. Take a look at the chart below. Notice how the bands contracted when the BTC/USDT traded in a quiet, relatively stable fashion. Then look at how the bands expanded when the price experienced large price changes up over short periods of time.

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Overbought and Oversold

It's important to understand what makes Bollinger Bands expand and contract because many crypto investors use Bollinger Bands to measure when a cryptocurrency may be overbought or oversold. But this strategy is by no means foolproof. So, what's the approach?

Generally, traders define a Bollinger Bands overbought condition when asset price moves above the upper band. Conversely, asset price may be oversold when it moves below the lower band. But here’s the catch: asset price can remain overbought or oversold for an extended period. For example, take a look at the chart below.

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One thing experienced traders will do is when applying Bollinger Bands to measure overbought and oversold conditions, be mindful of the width of the bands. Avoid seeking overbought or oversold conditions when the bands are expanding. Instead, look for these conditions when the bands are stable or even contracting.

Key Takeaways

  • Bollinger Bands was designed to discover opportunities of when a cryptocurrency such as Bitcoin and Ethereum is oversold or overbought.
  • The upper and lower bands measure volatility.
  • The closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market.
  • Any breakout above or below the bands is a major event and need to pay attention.
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