The main purpose of Bollinger Bands® is to help traders determine whether assets are reasonably priced, and whether prices in the market are stable or may be moving toward different levels. This information can be potentially helpful for investors because it can determine the following: whether they are paying a fair price for the asset, whether it is too costly, or whether it is a bargain purchase that could result in profit in the future. In addition, Bollinger Bands may be readily applied to forex trading and designed to complement any price chart.
What Are Bollinger Bands In Forex?
Bollinger Bands® are not recommended as an exclusive method for understanding price movements. Functionally, Bollinger Bands work best in combination with other indicators, such as the moving average. Further, the Bollinger Bands indicator is designed for basic trend analysis and to complement other technicals such as stochastics, moving average convergence and divergence, wave patterns and price gaps.
Bollinger Bands® were developed by John Bollinger in 1983, and they're a system under a registered trademark. Despite being trademarked, Bollinger Bands exist as a public domain indicator and are available to use free of charge on most forex trading platforms.
How Do Bollinger Bands Work?
The measurement system for the bands is based on price volatility. The "bands" are lines traced on a chart as averages and outer limits for prices. The region between the upper and lower bands is often referred to as an "envelope."
Within the system there are three lines—an upper line, a lower line and a middle line. The middle line is based on a moving average of price. This moving average is referred to as the "midpoint." It represents the relative center of the envelope and serves as a benchmark for current volatility. In outlining his method, Mr. Bollinger recommended the use of 20-day moving price averages for analysis.
The upper and lower band lines are based on a standard deviation of the price from the moving average. Standard deviation is a mathematical measurement for how spread out a group of numbers is on average. In the case of Bollinger Bands®, the numbers involved are prices.
The typical standard deviation used in the Bollinger Band calculations is 2.0 and the base pricing data set may be a periodic high, low, open, close, midpoint or median. When trading Bollinger Bands, these values can be tailored to any strategy or objective. On most analysis systems, traders can change the periods, and thus the standard deviation, used in the calculation of the bands according to their preferences for trading time horizons.
How To Trade Forex With Bollinger Bands®
In practice, there are countless ways to trade forex with Bollinger Bands. One may implement trend, reversal, breakout or rotational methodologies with the Bollinger Bands trading indicator. Ultimately, the only limits of the tool's application is the trader's imagination.
One of the most common uses of Bollinger Bands is to identify trends and trade related strategies. Within the context of Bollinger Bands, a pricing trend consists of price action that follows either the upper band (bullish) or lower band (bearish). Subsequently, a price trend that remains narrow and in the direction of either the upper or lower band line is considered to be a strong trend. In this way, the upper and lower bands serve as the trader's guide to trending markets.
Analysts pay particular attention to when prices are trending near the upper or lower bands. Prices that are near the upper band are considered to be "overbought," and good prospects for selling. Similarly, prices that are near the lower band are considered to be "oversold," and good prospects for buying. Both of these events are viewed as being setups for a reversal or rotational Bollinger Band trading strategy. However, in the event that a price bar closes outside of the upper band or lower band, trend extension is more likely.
Signals: Trading Tops And Bottoms
The Bollinger Bands analysis system uses visual patterns to determine when the market has reached a high or low price. Some of the main "signals" for price trends are patterns that come in the shapes of the letters "W" for market price bottoms and "M" for tops. When a price of a given asset reaches a low on the chart, chartists look for repetition of that low at the second bottom on a "W" shape for confirmation that the price will not likely go lower.
The middle price peak before the second downward trend on the "W" pattern is understood to be the "breakout" point. If the price rebounds above this point following the second low of the "W" shape, then the price is understood to have broken out of the downward trend and initiated a trend on a new upward movement.
The same type of Bollinger Bands analysis holds for determining the top of a price trend, only in an inverted manner. If an upward movement falls from a peak, analysts look for a second repetition of the peak in an "M" shape. When the price falls to below the middle "breakout" point in a second downward movement on the "M" shape, the price is determined to be on a new downward trend.
The fact that a price breaks beyond the upper or lower Bollinger Band® is not necessarily considered a "signal" of a possible new price movement. Analysts note that prices can frequently trend along the lines and break out on occasion When this occurs, the movement is called a "tag," and it is considered to indicate that a price is at a high or low within a shorter term price trend. However, it has been seen that frequently when price breaks the upper or lower Bollinger Bands, it will fall back within the band toward the midline.
Are Bollinger Bands Reliable?
When John Bollinger created Bollinger Bands in the early 1980s, technical analysis was still in its infancy. At the time, the study of price action was widely viewed as being secondary to traditional fundamental analysis. As the years passed, this perception changed. In the contemporary marketplace, the Bollinger Bands indicator has earned a reputation as being a dependable, reliable technical tool.
Of course, no indicator is infallible. Although Bollinger Bands provide the trader with a user-friendly means of identifying market state, they can provide false signals. Periods of extreme volatility or sparse participation can undermine the efficacy of any Bollinger Band strategy.
Fortunately, there are a few steps that users can take when trading Bollinger Bands likely to improve performance. Among the most important are combining with other indicators, practicing proper risk management and staying abreast of pertinent fundamentals. If thoroughly devised and applied consistently, your Bollinger Bands strategy can provide a solid foundation for profitable long-run futures, equities, or currency trading.
What Are Bollinger Band Squeezes And Bounces?
There are two primary events to watch for when conducting Bollinger Band analysis: squeezes and bounces. Each is a unique phenomenon with separate strategic applications.
The Bollinger Band squeeze occurs when volatility drops to low levels and the upper band and lower band converge or "tighten." Under this scenario, the market is entering a rotational phase; accordingly, participation is likely limited and price action choppy. In an attempt to profit from a Bollinger Band squeeze, traders frequently employ rotational trading strategies.
To execute, one sells from the upper Bollinger Band and buys from the lower Bollinger Band. The profit target is typically the midpoint and stop loss locations fall above or below the upper and lower band.
Contrary to the squeeze, the Bollinger Band bounce strategy is best executed in active market conditions. Upon price sloping upward or downward between the mid moving average and the upper band or lower band, trading the bounce strategy may be appropriate.
In the live market, the bounce strategy is executed much like a squeeze; one sells from the upper Bollinger Band and buys from the lower Bollinger Band. However, greater profit targets are warranted as volatility is significant and stop losses extended.
Volatility Trends And Bollinger Bands
Bollinger Bands® are also used for examining the potential volatility of the market. In particular, when the band "envelope" narrows significantly, it is considered to be a sign that volatility will soon increase. This can be helpful in cueing investors that buying or selling opportunities may be approaching.
When trading Bollinger Bands, monitoring the distance or "spread" between the upper band and lower band is one of the most important aspects of using the indicator competently.
In addition to using Bollinger Bands® as a tool on their own, they are frequently used with other indicators such as momentum, volume, sentiment, open interest and inter-market data.
One particularly popular indicator for use with the Bollinger Bands® is the Relative Strength Index (RSI), a "momentum oscillator" developed by J. Welles Wilder Jr. The RSI is used to compare upward movements in closing prices to downward movements over a selected period of time. Like other charting techniques, this index can be used to find signals that could determine bull market trends, bear market trends, trend reversals and large price corrections.
This article was last updated on 8th June 2021.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…