In the previous article, we shared about how Moving averages can be used in automated cryptocurrency trading. In this article, we will be sharing another popular technical indicator used by traders – Bollinger Bands.
What are Bollinger Bands?
Bollinger bands are momentum indicators that allow users to observe the strength of price changes. Bollinger bands are able to reflect changes in price trends and serve as a measure of price volatility.
Bollinger bands consists of three essential components:
- 1: A centerline: Usually a 20-Day Simple Moving Average
- 2: An upper band: A line plotted two moving standard deviations above the center
- 3: A Lower band: A line plotted two moving standard deviations below the centerline
Similar to EMAs, there are no “correct” parameters for the plotted lines, and they can be adapted for different situations. CryptoHero makes use of the 20-Day Simple moving average and plots the bands 2 Standard Deviations away from the SMA.
Bollinger bands allow us to observe changes in price volatility. For instance, if the price of BTC was consolidating and trading sideways, the Bands would narrow and move closer to the centerline. Conversely, if there is a sudden rise in price fluctuations, then the bands would widen and move away from the centerline as pictured above.
Apart from measuring market Volatility, Bollinger bands can also provide insights into areas of support and resistance.
The upper band is often used as a dynamic indicator of resistance levels. This means that traders do not expect prices to rise higher than the upper band. As pictured above with red arrows, prices rarely rise above the upper band and usually fall after nearing the upper band.
Conversely, the lower band is used as a dynamic indicator of support levels. This means that traders do not expect prices to fall below the lower band. Similarly, as pictured above with orange arrows, prices rarely fall below the lower band and usually rise after nearing the lower band.
It can also be observed that prices tend to gravitate around the centerline, with prices returning to the centerline after approaching the upper and lower bands. This pattern gives rise to a common use of Bollinger bands in cryptocurrency trading – mean reversion.
Mean Reversion Strategy
With mean reversion, traders expect prices to gravitate towards a prevailing price trend represented by the centerline. Thus, when prices hit the lower band, it is considered to be oversold – trading at a discount. Conversely, when prices hit the upper band, it is considered to be overbought– trading at a premium.
For instance, when BTC is overbought, prices are expected to fall towards the mean. Conversely, when it is oversold, prices are expected to rise back towards the mean. If a trader is bullish on Bitcoin and expects the prices to rise, then he would open a position when prices touch the bottom band and close his position for a profit when prices rise towards the upper band.
CryptoHero uses the mean reversion strategy for automating trades with Bollinger Bands as outlined in our documentation.
Summary
While the mean reversion strategy is one of the most popular trading strategies out there, relying solely on Bollinger Bands as an indicator may cause a trader to incur losses. Traders often use indicators together with one another to make more confident trades. CryptoHero allows users to use Bollinger Bands in conjunction with other indicators such as Exponential Moving Averages.
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