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Forex Trading Analysis: Applying Bollinger Bands, An Absolutely Necessary Device For Technical Foreign Exchange Traders
Bollinger bands on currency trading charts are used just as on equities and options trading charts, as an indicator to make the trader aware of 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 certain number of periods, normally 20. The upper and lower lines are at a certain number (usually 2) of standard deviations calculated with reference to the number of intervals used for the center band.
Bollinger bands were discovered by John Bollinger in the 1980s. The hypothesis behind them is that prices will ordinarily remain within 2 standard deviations of the average, which here is the moving average used to plot the middle line. This means that as prices reach the upper and lower band lines, a reversal is signaled to keep the prices within the bands.
They are also an indicator of amplitude. Wider bands show signs of a more volatile market than narrow bands.
Traders use Bollinger bands in several various ways but these are the two most popular ones:
1. Identification of overbought and oversold market conditions
On the basis that prices are likely to stay within the bands, some traders will use Bollinger bands as an indicator to sell when the price soars above the upper line and buy when it slides below the lower line. Generally they intend to close their trade when the price approaches to the central line.
Caveat is necessary here, however, as these movements outside of the bands may just signal a powerful trend unfolding in that direction. So you could be caught on the wrong side of a powerful trend in some cases. John Bollinger himself recommended always examining against different indicator. Possibly the most effective for this purpose are non-oscillating indicators such as trend lines or chart patterns.
2. Identification of contraction and forecasting breakout
As we have seen, the bands will diverge and converge based on the volatility of the market over the measured past intervals. When they converge so that their area becomes narrow, this is called contraction. Some traders will act assuming that contracting bands is a signal of a significant breakout and place both buy and sell orders outside the bands.
The danger here is that there can often be a misleading break where the prices will stretch outside the bands briefly prior to turning. 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 currency trading 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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