Introduction to Bollinger BandsĀ®
Bollinger BandsĀ® are a technical analysis indicator that is used by traders to understand the price volatility of a particular financial instrument, such as a currency, and to identify when the financial instrument is overbought or oversold.
Bollinger BandsĀ® were created and copyrighted by John Bollinger, a well-known technical analyst and trader, in the early 1980s.
Bollinger BandsĀ® are used by technical traders in all financial markets, including the forex market.
What are Bollinger BandsĀ® and how do they work?
Bollinger BandsĀ® comprises three bands: A simple moving average (SMA) band in the middle, an upper band above the SMA, and a lower band below the SMA.
The upper and lower bands are typically two standard deviations, namely a positively (upper band) and a negatively (lower band), +/- from a 20-day simple moving average (SMA) of the price of a security. The distance between the upper and lower band is determined by standard deviations. It is the preference of the trader to decide how many standard deviations he or she wants the indicator set at. Generally, two standard deviations from the average are used.
Standard deviation is a mathematical formula that measures volatility, indicating how the price of a security can differ from its true value. Bollinger BandsĀ® are a useful tool for forex traders because by measuring volatility, they adjust themselves to market conditions and, therefore, traders are enabled to find almost all of the price data needed between the two standard deviations.
Basically, the simple moving average (SMA) provides a base for the upper and lower bands. Bollinger BandsĀ® are mainly utilized to ascertain overbought and oversold levels in order to sell when the price of a security, such as a currency, reaches the upper band and to buy when the price reaches the lower band.
Bollinger BandsĀ® are a useful tool to determine current volatility in the market. Contracted bands are an indication of low volatility (with the probability of a breakout), while the bands will widen as the market becomes more volatile (with the potential for a subsequent period of low volatility).
How to trade forex with Bollinger BandsĀ®
Of all the different techniques involved in using Bollinger BandsĀ® in forex trading, the two most popular ones are: Utilizing market trends and the Bollinger Squeeze.
Utilizing market trends
Trading uptrends with Bollinger BandsĀ®
Traders who prefer trading in markets with strong bullish trends should look for a situation where the currency price oscillates between the 20-day moving average and the upper band.
Bollinger BandsĀ® enables a trader to make important trading decisions by assessing how strongly a currency price is increasing (uptrend) and when it is potentially losing strength or reversing.
Typically, when the price is in a strong uptrend it will touch or run along the upper band. When the price fails to do that, it is a sign that the uptrend may be losing momentum.
Even during an uptrend, prices are inclined to fall for periods of time, referred to as pullbacks. If the price is moving strongly during an uptrend, the pullbacks will take place near or above the moving average (the middle band or line).
When the price crosses the 20-day moving average and touches the lower band, it is a warning sign of a reversal. If the price rises again, it probably will not be able to reach the upper band or the recent price high again.
Trading downtrends with Bollinger BandsĀ®
A constant downward trend is typified by price movements between the 20-day moving average band and the lower band.
Typically, when the price is in a strong downtrend it will touch or run along the lower band. When the price fails to do that, it is a sign that the downtrend may be losing momentum.
During a downtrend, prices of currencies may rebound for certain time periods, called pullbacks. Typically, during a downtrend, when the price of a currency is moving strongly lower, then pullback highs will occur near or below the moving average (middle) band. The pullbacks indicate selling strength when they stall out near the middle band.
When the price is in a strong downtrend and touches the upper band, it is a warning sign of a price reversal. If the price declines again, it probably will not be able to reach the lower band or the recent price low again.
Forex trading and the Bollinger Squeeze
A Bollinger Squeeze occurs when the bands squeeze together, constricting the moving average.
A squeeze indicates a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities.
In contrast, the wider apart the upper and lower band move, the more the probability of a decrease in volatility and the greater the chance of exiting a trade.
When high volatility returns to the market, the upper band will rise and if the price breaks the upper band, it will imply a bullish breakout. Conversely, the lower band will fall and if prices breach the lower band, a bearish breakout is imminent. Generally, the longer the squeeze, the stronger the expected breakout.
However, the breakouts are not often accurate or trustworthy signals that prices will behave in a certain way. Price volatility alone is not enough to enable traders to make decisions to trade successfully.
In closing
The interpretation of Bollinger BandsĀ® on a chart pattern is very much dependent on the trader. Although quite useful as a technical indicator, they are not perfect and have flaws. They are just a tool and do not deliver reliable information all the time. The moving average number is not set in stone. The parameters of the moving average are the choice of the trader.
Using Bollinger BandsĀ® alone as a technical indicator in forex trading is not a reliable approach to analysing the forex market. Utilizing Bollinger BandsĀ® with other indicators will enable a trader to make better-informed decisions. Even John Bollinger suggested that the Bollinger BandsĀ® are used in combination with two or three other un-correlated indicators.
The best combinations with Bollinger BandsĀ® are probably oscillators such as relative strength index (RSI) and moving average divergence convergence (MACD). Bollinger BandsĀ® are useful to indicate value price areas in the market. However, they do not identify the price strength or weakness in such areas. This is where the oscillators come into play.
