The Bollinger bands were first created by an experienced technician in the markets. Bollinger bands were developed using a technique that applies moving averages along with two trading bands placed above and below the moving average. These bands are formed by simply adding or subtracting the standard deviation from the calculation instead of calculating the normal moving average.
The standard deviation is a statistical calculation that provides an insight into the volatility of the stock and how it can vary from its true value. As a result, Bollinger bands can be considered as most suitable to get an insight into the market conditions by constantly adjusting themselves according to the measured volatility in price.
The Bollinger bands are very useful to any trader as all the price data is clearly available between these two bands. Here is some information about how this indicator works, how to calculate it and how to use it for trading.
KEY TAKEAWAYS
- Bollinger Bands are a type of technical analysis used to lay out trend lines two standard deviations away from the simple moving average price of a financial instrument.
- Bollinger Bands are useful for demonstrating changes in volatility of a financial instrument.
- Forex traders might use the bands to set sell orders at the upper band limit and buy orders at the lower band limit.
- To address certain risks with Bollinger Bands, traders should determine entry and exit points near the lines and take action accordingly.
- Another technique is to set a second set of Bollinger Bonds only one standard deviation from the moving average, creating channels that can be used for determining trades.
Understanding Bollinger bands
The Bollinger bands include two price channels located above and below the center line. The center line in the Bollinger bands is nothing but the exponential moving average, and the price channels are the standard deviations of the stock that is being studied. These bands will expand whenever the price of a commodity becomes volatile. Similarly when there is a strong trading pattern, the band will contract.
Stocks often move in a trend with little volatility from time to time. To better understand these trends, the traders often uses moving averages to filter the price action. This allows the traders to learn about important information pertaining to how the stock has been trading in the market. The markets often consolidate after a sharp trend of rise and fall. As a result, the investors start trading in a very narrow fashion by making bids slightly above and below the moving average. To monitor this particular behavior in a more organized manner, the traders use certain price channels encompassing the activity around the trend.
When the stock prices are constantly in the upper region of the Bollinger Band, the prices are assumed to be overbought. Similarly, when they touch the lower band, the prices are assumed to be oversold. This triggers a buy signal in the market. The Bollinger bands also indicate a change in trend. The upper and the lower bands are considered to be price targets in the market. When the price moves off the lower band and crosses the 20 day moving average, the upper band is considered to be the price target. During this situation, if the price moves below the 20 day moving average, it is a clear indication of a reversal in the trend.
Usage in trading
You can use the following assumptions when trading Forex using the Bollinger Bands indicator:
- The currency pair’s range of motion is within the upper and lower lines. If the price comes close to one of the boundaries, the opposite boundary will serve as the price’s next target unless there is a breakout.
- If the price is fluctuating near the upper or lower band for too long, the pair is in the uptrend or in the downtrend, respectively. The opposite boundary can be viewed as the support or resistance line.
- The distance between the bands is decreasing during the periods of low volatility. A strong trending movement usually follows such periods after breakout.
- Two new local maximums or minimums serve as the direction change signal. One should be outside of the Bollinger Bands, another — inside them.
- Closing above or below the bands range is a signal for trend strengthening and continuation if the boundary line is directed the same way as the price.
- If the price goes above the upper line but the line is heading down, it is a sell signal with the lower line as the target. The same is true for the opposite direction. Requires confirmation.
- The indicator provides no 100% correct forecasts for the currency pair’s movement. You have to do additional market analysis in case the price touches one of the lines and you have to find confirmation signals from other indicators or from the chart patterns.
- Standard settings are based on the simple moving average with the period of 20 and the number of standard deviations equaling 2. The indicator was developed for equities trading. Considering the fact that each trading instrument has its own unique properties, it is worth experimenting with the settings by changing the moving average type and period, and by adjusting the number of standard deviations.
How do Bollinger Bands work?
The Bollinger Bands tend to squeeze when the market is less volatile and send a sharp price move signal in the market’s direction. Such price moves lead to a price trend. However, when you notice the bands separating rapidly, it sends a more volatile market signal that leads to an end in an existing trend. The Bollinger Bands consist of three lines:
- The simple moving average line
- The lower band, two standard deviations below the simple moving average line
- The upper band, two standard deviations above the simple moving average line
How do these bands send a signal to the trader?
- When the currency pair prices touch the lower band and cross the moving average line from above, the upper band is known to be the profit target in that time period
- When the currency pair prices touch the upper band and cross the moving average line from below, the traders receive an entry point signal at the lower band
Calculating Bollinger Bands
Bollinger Bands are calculated using moving averages. Once you have the moving average, the standard deviation of the closing price is calculated over the same period as that of the moving average. This standard deviation is then multiplied by the a factor, which is normally 2. Once you have finished this calculation, you will have to obtain the upper and the lower bands. The upper band is calculated by adding standard deviation that has been multiplied by the suitable factor to the available moving average. The lower band in the Bollinger Bands is calculated by subtracting the standard deviation which has been multiplied by a suitable factor from the available moving average.
The DJIA is usually calculated with either the 20 or 21 day moving averages along with the percentages in the range of 3.5 to 4.0 to obtain the upper as well as the lower Bollinger Bands. The 20 day simple moving average is reviewed and calculated by using the closing prices of the past 20 days and finding the arithmetic average of these values. To calculate the standard deviation, subtract the simple moving average from each of the closing values and square the same. The squares obtained are then added and another arithmetic average is obtained. The square root of this average itself is the standard deviation.
To calculate the upper band, simple add the moving average to the product of standard deviation and the chosen factor (preferably 2) and for the lower Bollinger band, subtract the product of the factor and the standard deviation from the moving average. Plotting these three values in an extrapolated manner will provide you with the indicator known as Bollinger Bands.
Bollinger Bands strategies – get to know the essential ones.
When it comes to Bollinger Bands strategies in Forex, we would like to single out a few of the most important ones that you must keep in mind during trading. Let’s start from the first, shall we?
#1 Bollinger bands forex scalping strategy
Here is an example if you choose a Bollinger bands forex scalping strategy. We have the GBP/USD currency pair. Using Bollinger bands on standard chart settings, which are 20 lengths with two standard deviations, means that you will be looking for a fiat Bollinger band.
The rules of a Bollinger band’s forex scalping strategies are that you will go short with a ten pip stop once the price touches the upper band.
On the other hand, you will exit the trade when the price touches the lower band. You will go long once the price touches the lower band with a ten pip stop. Once the price touches the upper band, it is time for you to exit the trade.
#2 Double Bollinger bands forex strategy
When it comes to the Double Bollinger Band strategy, a trader should know that it uses two Bollinger Bands to filter exits and entries in the foreign exchange market. This strategy focuses on entering long trades when the price breaks above one standard deviation, and opposite, entering short transactions once the price breaks below it.
A double Bollinger bands forex strategy applies to ranging markets as a breakout strategy. It can also be used when assessing the slowdown of an existing trend.
Bollinger Bands Set-Ups
A Forex trader interested in a Bollinger bands strategy should understand the setup.
There are upper and lower bands, each set at a distance of two regular deviations from the 21-day simple moving average security.
For that reason, the Bands show the volatility of the price concerning the average. In addition to that, Forex traders can expect price movements anywhere between two bands.
Traders can use these bands to place sell orders at the upper band limit and purchase orders at the lower band limit. What is vital to note is that this particular strategy works fine with currencies that pursue a range pattern. However, it can be pricey to a trader if a breakout occurs. That’s why it is essential to set the limits.
Summary
In summary, we’d like to point out that there are many uses for Bollinger Bands. It includes overbought and oversold trade signals. In addition to that, traders can add multiple bands, highlighting the strength of the price movements.
Besides the overbought and oversold trade signals, Bollinger Bands could look for volatility contractions usually followed by clear price breakouts, which ideally have significant volume.
However, it’s crucial to understand that Bollinger Bands are not confused with Keltner Channels. Even though these two indicators are somewhat similar, they’re not the same.
FAQs
Do Bollinger Bands work in Forex?
Bollinger Bands can work in Forex, like other technical indicators, but success depends on the interpretation and discretion of the individual Forex trader. Bollinger Bands cannot create 100% accuracy or automatic trading signals.
How do you trade Forex with Bollinger Bands?
Bollinger Bands measure volatility and use standard deviations. Forex traders can use them as tools for range trading, trend trading, and reversals.
How does the Bollinger Band work?
The Bollinger Band consists of three bands, where the middle band acts as a baseline. The upper and lower bands are 2 standard deviations above and below the middle band, but traders can alter the deviation settings. Bollinger Bands measure volatility.
Are Bollinger Bands reliable?
Bollinger Bands can provide reliable insights concerning volatility and trends but cannot work with 100% accuracy, like any other technical indicator.
