How to Trade Forex with Bollinger Bands

April 26, 2013 02:27 AM

Bollinger Bands were invented by the analyst John Bollinger in the 1980’s and are a popular tool used by traders to analyze the financial markets. Bollinger Bands are placed two standard deviations away from the simple moving average and are excellent measures of volatility. The bands seek to provide a relative definition of what is high and what is low and are adaptive to the market. Default parameters consist of 20 periods and two standard deviations but can be adjusted as necessary. The inventor, John Bollinger, also provides 22 rules for using the bands. The most important rules are provided here, the rest can be found online.

Bollinger Bands can be used to compare price action and indicator action to arrive at rigorous buy and sell decisions.

Bollinger Bands can be devised along with other technical indicators to provide buy and sell signals. However, the success of any strategy relies on the combination of various indicators and using the correct settings for each market. Some traders may find success buying/ or selling the market when it breaks out of the bands, whereas some traders may use the bands as reversal opportunities.

Tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.

Bollinger Bands example chart

When the market touches one of the bands, it signals that the price is either high or low, it does not necessarily indicate a buy or sell signal although strategies can be devised to use the bands in such a way. They can also be combined with other indicators to develop break out or mean reversion systems.

In trending markets price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.

Bollinger Bands example chart

Buying the market when it hits the lower Bollinger Band or selling when the market touches the upper band is best for choppy markets, with no real direction. However, for trending markets like USDJPY above, the price often moves along the upper or lower band with great consistency.

Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.)

When the market closes outside the Bollinger Band, it is first a signal of a breakout and not a reversal. This means that a trade should be entered in the direction of the breakout and not in the opposite direction. A reversal trade should be entered only if the market then comes back inside the band and starts to move back to the middle.

In the Bollinger Band, ‘BandWidth’ is used to indicate how wide the Bollinger Bands are and is normalized using the middle band. The BandWidth is four times the coefficient of variation using the default parameters.

Rule 19: BandWidth has many uses. Its most popular use is to indentify "The Squeeze", but is also useful in identifying trend changes.

Bollinger Bands example chart

When volatility drops, the Bollinger Bands come closer together and form a ‘squeeze’ scenario. When this happens, an explosive directional move is never far away as can be seen in the above chart.

Bollinger Band can be used in many ways are not necessarily restricted to price charts. They can also provide interesting signals when used against volume, momentum, or other sentiment indicators. As such, they are one of the most flexible indicators around.


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