Trading Bitcoin with the Bollinger Bands

This article outlines how to use the technical analysis tool Bollinger Bands to trade bitcoin. Developed by trading veteran John Bollinger in 1983, the tool has stood the test of time with Bollinger himself frequently analysing and commenting on the cryptocurrency market.

Bull and Bear in Frankfurt. Source: Wikipedia.

Overview

• Bollinger Bands are based on volatility, which is cyclical and predictable. Low volatility environments eventually lead to periods of high volatility, and vice versa.
• The Bollinger Bands are composed of a simple moving average (20-period by default) and an upper and lower band that are set to 2 standard deviation by default.
• ‘W bottoms’ should be used to setup a long position and you should enter once there is a display of strength in the asset.
• ‘M tops’ should be used to set up a short position but requires more confirmation than a bottom. Enter the short once there is a display of weakness.
• The ‘Bollinger Squeeze’ can be identified with Bollinger Bands and the BandWidth indicator. ‘The Squeeze’ allows us to identify and trade the breakout at the beginning of a trend.
• The ‘Bollinger Bounce’ is a reversal strategy. We look for a buy position once the price action touches the lower band, and an oscillator is positive. We look for a sell positions once the price actions touches the upper band, and an oscillator is negative.

What are the Bollinger Bands?

Bollinger Bands are curves drawn in and around the price structure consisting of a moving average (a middle band), an upper band and a lower band that enable you to identify whether the price of an asset is relatively high or low.

We consider the price to be relatively high if it is near the upper band, while we view it as relatively low if the price is nearer the lower band.

The upper and lower bands are set to a value equal to two times the standard deviation of the asset’s price history, which is used to ensure that the Bollinger Bands adapt to changing market conditions. The middle band is, by default, the same as a 20-period simple moving average.

You can use the Bollinger Bands when trading on the Interdax platform. When on the trading chart, click on Indicators then scroll down (or type Bollinger Bands in the search box) and click on the ‘Bollinger Bands’ indicator. You can click on the screw symbol on the upper left-hand side of the chart to change the settings of the Bollinger Band, as well as the colour.

Bollinger Bands on the Interdax platform.

How to Use the Bollinger Bands

Since the Bollinger Bands are used to define a high price and a low price relative to its past performance, we can use the Bands along with other indicators to form buy and sell decisions.

While we can think of the price hitting the upper band as motivating a sell (and price hitting a lower band as motivating a buy), it is important to remember a tag of the upper or lower bands is not a sell or buy signal by itself.

Bollinger Bands can be used on any timeframe, but the moving average period and standard deviation should be reduced or increased depending if you are trading on higher or lower timeframes. The default settings are a 20-period moving average, and standard deviation of 2. Lower these settings to 15 and 1.5 for a lower timeframe or to 25 and 2.5 for longer timeframes.

Using Bollinger Bands with Price Patterns

You can use the Bollinger Bands to trade certain price patterns.

For instance, the ‘M’ and ‘W’ patterns found in the price action can be combined with Bollinger Bands (and volume) to enter trades with a high chance of success.

Ms and Ws generally form at turning points in the market and are the most common pattern found at tops and bottoms.

‘W Bottom’ Pattern

For a valid ‘W bottom’ pattern, we should look for the first low (usually outside of the Bollinger Bands) to be lower in relative terms as compared to the second low (which is always inside of the Bands).

A W bottom identified with the Bollinger Bands. Look for bullish confirmation once the W pattern forms and go long.

Volume should also be higher on the first decline. The second low does not have to be beneath the first low, and even if it does drive to a fresh low, if it remains inside the Bollinger Bands then it is not a new low on a relative basis. W bottom patterns are invalidated when the second low is beneath the lower band.

Once you’ve noticed a W bottom, you can go long when the asset displays some strength. For instance, you can wait for a day of strong appreciation, with a trading range and volume greater than average. To limit your risk, a stop order can be placed just below the most recent low of the W pattern and you can move it upward when reasonable.

The chart above shows an example of a W bottom for BTC-USD. Following the second low inside the Bands, a bullish candlestick was printed which closed at $7,630 which would have motivated an entry into a long position. A stop would have been placed just below the second low around $7,465. BTC-USD went on to reach highs near $8,200 immediately after the W bottom.

‘M Top’ Pattern

M top patterns consist of a rally, then a pullback, a test of the resistance established by the highs of the preceding rally, then followed by the start of a downtrend. M top patterns are the opposite of W bottoms, where a fresh high is established outside of the Bands and a second high is posted within the Bands.

An M top pattern identified by the Bollinger Bands. Once the M pattern has formed, look for bearish confirmation to go short.

The chart above illustrates an example of a M top. The first high is outside of the Bands while the second high is inside the Bands.

Volume is larger on the first high but declines on the second high, suggesting that interest in an upward move is dwindling. Following the second high, a large bearish candlestick was printed and the swift momentum should have signalled to the trader to enter a short position. With an entry around $12,400 once selling volume started to pick up, the price eventually fell to lows near $11,200.

A ‘Triple Top’, also known as a ‘Head and Shoulders’ pattern, is also a very common pattern. Volume in a Head and Shoulders pattern typically rises on the left side of the pattern, wanes across the middle then increases again as the downward move gets underway.

To enter a short trade after a Head and Shoulders pattern, we should look for a re-test of the neckline after we have observed signs of weakness (greater than average volume and greater than average trading range). Usually, there is a countertrend rally that will try to break above the neckline once it is broken.

‘Three pushes to a high’ is another pattern to be aware of, where the first push will be outside the upper band, the second push will establish a new high and touch the upper band, but the third high fails to touch the band. We should look for volume to fall steadily as three pushes to a high unravels.

Three pushes to a high. The first high is above the upper band, the second high touches the upper band while the third high is within the bands.

We can also use the %B indicator to identify three pushes to high, where the oscillator should display lower highs.

Treat Bottoms and Tops Differently

It is worth keeping in mind that bottoms are generally easier to spot and clearer than tops, since the underlying psychology of a market is very different in bottoms as compared to tops. Bottoms are associated with fear, while tops are associated with euphoria.

As a result, bottoms tend to be sharper, more dramatic and take less time. On the other hand, tops are more prolonged and harder to identify.

Bollinger Bands can also be used to identify high or low volatility conditions which can form part of a strategy trading breakouts or trading ranges. There are also two simple strategies for trading breakouts and ranges respectively: the Bollinger Squeeze and the Bollinger Bounce.

The Bollinger Squeeze

One strategy that can be used with Bollinger Bands is known as the “squeeze”. The bands are driven by volatility, and the squeeze is just a reflection of that. While price action is not cyclical and predictable, volatility is.

A squeeze refers to the width of the Bollinger Bands narrowing and shows that volatility is low in the market. The trading range narrows and the Bollinger Bands tighten around the price action. When volatility is low, we should be keep an eye out for a breakout and enter a position before volatility returns to the market.

One definition of a squeeze is a six-month low in volatility (as measured by the width of the bands).

Once the price closes above the upper (or lower bands) when they are constricted tight together, then we have a breakout and can buy (or sell) using this signal. As volatility returns to the market, it usually establishes a new direction. In trending markets, price action can climb up the upper band (or climb down the lower band), and is known as walking the band.

Using the BandWith Indicator to Identify Squeezes

To identify Bollinger Squeezes, we can use an indicator derived from the Bollinger Bands — known as BandWidth.

The BandWidth indicator tells us how wide the bands are (calculated as the difference between the upper and lower band, all divided by the middle band) and was created to measure the Squeeze.

Using the Bollinger Bands and BandWidth indicator to identify a Bollinger Squeeze.

For a squeeze, generally we should look for the lowest BandWidth reading in six months.

BandWidth also plays a role in spotting the beginning and ends of trends. When the BandWidth is narrow, it tells us that volatility is low. A breakout from the trading range is usually accompanied by an expansion in the BandWidth and generally develops into a sustainable trend.

BandWidth can also be used to identify the end of a trend. In this case, the indicator flattens out or turns down enough to reverse the direction of the Bollinger Band on the opposite side of the trend, i.e. the lower band moves south in an uptrend, or the upper band moves north in a downtrend. This is known as ‘Expansion’ and is the opposite of a ‘Squeeze’.

Head Fakes

One thing to be aware of when looking at Squeezes is what is known as ‘Head Fakes’ — which is where a Squeeze appears but the price will make a short breakout in one direction but then turns and surges in the opposite direction.

To deal with Head Fakes, you can wait for the move to unravel before entering, or you could take an initial position in the fake’s direction of the and set a stop loss order behind the position to reverse the position if the breakout is a head fake.

Using Bollinger bands and BandWidth to identify Squeezes is outlined as a volatility breakout method in Bollinger’s book, Bollinger on Bollinger Bands. We look for a Squeeze and trade in the direction of the breakout.

Be sure to know the asset you are trading and how squeezes have played out in the past. If there is a squeeze that breaks out to the upside, you can use the lower band as a stop (or the upper band for a breakout to the downside) to limit your losses. As the new trend emerges, you can set a stop below the range of the breakout formation for an uptrend and move it upward each day (or period) the trade is open.

To reduce the risk of trading head fakes, we can combine the Bollinger Bands and BandWidth with volume indicators such as the Money Flow Index, Intraday Intensity or Accumulation-Distribution. For instance, the chart below shows how you can use the Accumulation-Distribution indicator to identify head fakes.

The Bollinger Bounce

While the Bollinger Squeeze is a trend-following system, we can use the Bollinger Bounce for reversals. To identify reversals using the Bollinger Bands, we look for multiple tags of the upper band that are accompanied by deteriorating indicators or multiple lower band tags with strengthening indicators.

For instance, if we want to clarify a bottom we look for a bottom in the B% indicator with what is known as a W bottom, if the B% forms a bottom higher than the previous bottom, then it could be a good setup for a buy.

You should confirm this with a volume oscillator, such as the Market Facilitation Index or the Volume-weighted MACD, and if it has a similar pattern, then it provides confirmation to buy on the first strong bullish candlestick. If the volume oscillator does not display a W bottom, then we should wait for another setup.

For tops, we would want more confirmation than for a bottom, as they usually take longer to form. The B% indicator should be lower on each push and confirmed by a volume indicator.

The best way to look for reversals is where an oscillator (such as MACD) is negative and there is a tag of the upper band (or the oscillator is positive and there is a tag of the lower band). For example, we could go long where B% is less than 0.05. Alternatively, a valid short setup would be where the B% indicator is greater than 0.95. The chart below shows an example.

The Bollinger Bouce. Use the %B indicator and MACD to buy when the price taps the lower band while the MACD is positive/%B is below 0.05. To sell, look for the price to tag the upper band while the MACD is negative/%B is above 0.95.

To learn about the Bollinger Bands in more depth, we can recommend the book Bollinger on Bollinger Bands for further information.

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Disclaimer: This blog post is for informational purposes only and should not be taken as financial advice.