Forex Trading Analysis: Using Bollinger Bands, An Absolutely Necessary Tool For Technical Currency Traders
Bollinger bands on currency trading charts are used just as on stock and options trading charts, as an indicator to alert the trader to a new unfolding movement, breakout or trend. They are made up of three lines or bands.
The middle band is a simple moving average over a specific number of periods, generally 20. The upper and lower lines are at a fixed number (usually 2) of standard deviations plotted with reference to the number of periods used for the center band.
Bollinger bands were invented by John Bollinger in the 1980s. The rationale behind them is that prices will ordinarily fluctuate within 2 standard deviations of the average, which here is the moving average used to plot the central line. This implies that as prices reach the upper and lower band lines, a reversal is anticipated to keep the prices within the bands.
They are also an indicator of volatility. Wider bands indicate a more volatile market than narrow bands.
Traders use Bollinger bands in several various ways but these are the two most predominating ones:
1. Identification of overbought and oversold markets
On the basis that prices are seeming to fluctuate within the bands, several traders will use Bollinger bands as an indicator to sell when the price closes above the upper line and buy when it drops below the lower line. Normally they intend to close their position when the price approaches to the central line.
Attention is important here, though, as these movements outside of the bands may simply indicate a powerful trend unfolding in that direction. So you could be stuck on the wrong side of a strong price movements in some cases. John Bollinger himself advised frequently checking against another indicator. Presumably the most effective for this function are non-oscillating indicators such as trend lines or chart patterns.
2. Identification of contraction and predicting breakout
As we have seen, the bands will diverge and converge consistent with the volatility of the prices over the measured past periods. When they converge so that their area becomes narrow, this is called contraction. Some traders will act on the basis that contracting bands is a signal of a significant breakout and place both buy and sell orders outside the bands.
The risk here is that there can often be a false move where the prices will expand outside the bands briefly before reversing. Because of this reason some traders rather do not act on the first move outside the bands. Again you should always check against another indicator on your forex charts, or use forex signals as a checking tool. A forex signal is a market forecast and a trading recommendation, which can be used as a confirmation, especially if comes from a reliable forex signal provider.
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