Bollinger Bands are very popular technical indicators among forex traders. The man responsible for the idea is John Bollinger – he created this technical trading tool in early 1980s.
Bollinger Bands – Technical Analysis and Forex Indicators
The primary idea of Bollinger Bands is to sell when price reaches the upper Bollinger band and buy when it falls down to the bottom Bollinger band. In forex market where price movements are going up and down this technique works well for determining your next trading strategy.
What do these Bollinger bands look like? There are two lines separated by a distance from one another. The distance changes along with the price movements. When there is not much changes in price movement the bands are close from one another, but when the price goes up, the distance between two lines increases. Bollinger bands add and subtract a standard deviation calculation that measures the instability of price movements enclosing at least 80% of the price inside the “tunnel” the bands create.
Another line which is a part of Bollinger Bands is the simple moving average right in the middle of the tunnel.
There is a lot of mathematics behind this, but we will not go too much into details. All you have to know is that
- An upper band is the simple moving average plus 2 standard deviations.
- A lower band is the simple moving average minus 2 standard deviations.
This definition should be enough! Your forex broker trading platform should have this tool available for you and so here we will discuss the application of Bollinger bounce rather then the actual calculations.
A volatility channel plots lines above and below a central measure of price. These lines, also known as envelopes or bands, widen or contract according to how volatile or or non-volatile a market is. Bollinger Bands® measure market volatility and provide lots of useful information, including:
- Trend continuation or reversal
- Periods of market consolidation
- Periods of upcoming large volatility breakouts
- Possible market tops or bottoms, and potential price targets
How to trade forex with Bollinger Bands?
There are several different techniques involved in using Bollinger Bands to trade the forex markets. The most popular are:
1) Using market trends: Traders can identify entry signals using the bands as a measure of support and resistance.
2) Bollinger Squeeze: Applying the volatility indications of the bands
When the market is quiet, the bands contract and when the market is LOUD, the bands expand.
Using Bollinger Bands as targets
By now you must have got an idea about the use of Bollinger bands. The most common way to use it is keeping the upper and lower bands as price targets. Suppose if prices bounce back from the lower band and cross above the 20-day average, then the upper band becomes the price target on the upside and vice-versa. Normally the price level oscillates inside the upper band and the 20 day average in case of a strong uptrend, whereas it just the opposite in case of a strong downtrend.
During a period of rising price volatility, the distance between the two bands will widen, whereas during a period of low volatility the bands will contract. Usually, the contraction and extraction come alternately. Okay. I will break it down for better clarity. Before proceeding further you should know that volatility is cyclical even when the price is not.
The price can bounce from one band to another, each time creating trading possibility. Think of Bollinger bands as two pin-pong players and the middle line (simple moving average) as their ball. When the simple moving average (our pin pong ball) is getting closer to one of the band (one of the excited players) it bounces off – just like the pin pong ball would do when one of the players hits it back!
Ok, great! Now we know where the word bounce in “Bollinger bounce” comes from. Now what? It is useful to understand that when you see the simple moving average approaching one of the bands it will almost certainly bounce back off!
Another imaginary example – let’s say that the simple moving average (the middle line) is a gas and the Bollinger bands form a sealed gallon. When you squeeze the gallon with a dangerous gas at some point the gallon explodes and the gas gets out. So, that’s exactly what happens with Bollinger squeeze – when Bollinger bands squeeze close to each other there is a great chance that there will be an “explosion”! If the middle line (the simple moving average) breaks through one of the bands, either the top or the bottom) it is believed that forex trend will continue in that fashion.
This strategy uses an indicator named ‘band width’. Band width is calculated with the following formula:
Band width = (upper Bollinger band value – lower Bollinger band value) / middle Bollinger band value
The idea behind this indicator is that when it hits a six-month low, traders can expect volatility to increase. At this point in time, a squeeze is triggered and the instrument’s price may move significantly.
Limitations of Bollinger Bands
Although Bollinger Bands are helpful tools for technical traders, there are a few limitations that traders should consider before using them. One of these limitations is that Bollinger Bands are primarily reactive, not predictive. The bands will react to changes in price movements, either uptrends or downtrends, but will not predict prices. In other words, like most technical indicators, Bollinger Bands are a lagging indicator. This is because the tool is based on a simple moving average, which takes the average price of several price bars.
How to interpret Bollinger Bands
Bollinger Bands are an effective technical analysis indicator, however, they do have limitations. Bollinger Bands are based on an instrument’s simple moving average, which uses past data points. As a result, the bands will always react to price moves, and not forecast them. In other words, Bollinger Bands are reactive, not predictive, and are often referred to as a lagging indicator, rather than leading.
Bollinger Bands reflect direction with the 20-period SMA and volatility with the upper/lower bands. As such, they can be used to determine if prices are relatively high or low. According to Bollinger, the bands should contain 88-89% of price action, which makes a move outside the bands significant. Technically, prices are relatively high when above the upper band and relatively low when below the lower band. However, “relatively high” should not be regarded as bearish or as a sell signal. Likewise, “relatively low” should not be considered bullish or as a buy signal. Prices are high or low for a reason. As with other indicators, Bollinger Bands are not meant to be used as a stand-alone tool. Chartists should combine Bollinger Bands with basic trend analysis and other indicators for confirmation.