Bollinger Bands use standard deviations to indicate market volatility with respect to price levels from a given time frame. This guide will focus on interpreting the calculations of this indicator and how it can be used to analyze the Forex market. To better understand this concept, you may visit the article about the Bollinger indicator on LiteForex.
Theory Behind Bollinger Bands
Bollinger Bands were named in the early 1980s after John Bollinger. Some may think of technical analysis tool as complicated, but ultimately, it works as follows:
- It starts with a line that indicates the price’s Moving Average of typically 20 days.
- On either side of this Moving Average (above and below), two trading bands are placed. Usually, with a space of 2 standard deviations.
- These 2 standard deviations are outlined so that 95% of the prices will fall between the bands.
- If the market price comes up to the upper end of the band, the market is expected to go back to the lower side.
Because price movements are volatile, they won’t stay at the same distance from the Moving Average line. When the volatility drops, the bands get closer, and it gets tighter. In contrast, significant price movements widen the bands. Depending on the market’s volatility within the 20-day period, the Bollinger Bands will contract or expand.
What Does It Mean?
Looking at the chart, when the bands are far apart and there’s a wide gap between them, it means that the current trend is coming to an end. On the other hand, an explosive movement may be underway when the bands are tight, with low market volatility.
Bollinger Bands Calculations
Forex traders usually notice three levels of the line when Bollinger Bands are plotted to a chart. Each line signifies a different boundary rate.
Below is a guide on how to compute each line and its indications:
Considered statistically high or expensive when trends fall within this band. It is calculated using the formula:
Upper Band = 20 days SMA + (2 x 20-day standard deviation)
Indicated as the simple moving average (SMA) that refers to the average price over a specific time. The period used for this is generally set to 20 days.
On the other hand, it’s statistically low or cheap when the trend falls within its scope. The formula is given as:
Lower Band = 20 days SMA – (2 x 20-day standard deviation)
Here are some strategies that utilize this tool:
Traders must be aware of when a possible reversal might happen and must be wary of the signs. Such as when a price drops below the lower band but is still near the higher interval, the trader can now eye the middle band.
When the price gap goes above the upper band but is still close to the lower interval, the trend signals a reversal on the next term. The trader can opt to take a short position and target the middle band.
Bollinger Band Squeeze
This is a strategy that makes use of the band’s width as a gauge. For instance, during a low that drags to six months, the volatility can be expected to be higher, thereby triggering the price to advance at a significant amount.
The occurrence of double bottoms indicates that the price will progress closer to the outside portion of the lower band. This signifies the price is lowering with substantial volume. There can be a brief bounce to the middle band after but will sink to the lower volume near the lower band. These observations can help the traders decide to jump from being sellers to buyers.
Bollinger Bands’ Effectiveness
Because this indicator uses historical data from 20 days, it’s only capable of reacting to the trend and helping traders what they can expect. However, it can not predict what will happen with the future of the market. Similar to other indicators, it has limitations and can sometimes provide wrong signals.
Some traders might already have proven strategies of their own, and Bollinger Bands may not be a suitable addition to an already accomplished process. Unless, of course, its defaults settings will be changed according to the trader’s preferences.
Several indicators can be paired together to make up for each of their limitations. What these indicators are will depend on how the trader plans to utilize them.
Other Technical Analysis Tools
Listed below are similar indicators that can be used along with Bollinger Bands to increase its accuracy:
- Stochastic Indicators – A popular momentum indicator that’s great for predicting trends’ reversals by comparing the closing price versus its prices within a certain period.
- Moving Averages – It’s useful in determining trend directions with the ability to change its settings to different time frames to suit the trader’s strategy.
- Keltner Channels – These bands that rely on volatility helps in pinpointing a trend direction with an adjustable exponential moving average of 20 periods.
Bollinger Bands indicate market volatility to help traders decide when to open and close trades. This technical analysis tool is not perfect, but it can be used with other tools and trading strategies to help traders perform better and understand the market.