Developed in 1980, the Bollinger Bands are one of the most popular tools for Forex traders around the world. Such as popular tool that is present in almost every platform offered by forex brokers as one of the default tools included in the charts.
Today, in ForexTraders’Guide, we are going to talk about the bands of Bollinger and how it can be used to trade in Forex. Keep reading, and we will learn how to calculate Bollinger Bands, what they tell us, and what are the most exciting strategies while trading Forex pairs.
What are Bollinger Bands
Bollinger Bands are a technical indicator developed by John Bollinger in 1980. It uses three lines located above and below the price structure and in the middle of the range created by both bands.
The middle line is typically a simple moving average, and the upper and lower bands are two standard deviations, positive and negative, from a 20-day Simple Moving Average.
Of course, and as it usually happens with all kinds of indicators in the financial world, it can be modified according to the circumstances and beliefs of every trader. However, the default construction remains the same as it was launched 40 years ago.
According to John Bollinger himself, Bollinger Bands are a type of trading bands and envelope.
Trading bands and envelopes serve the same purpose, they provide relative definitions of high and low that can be used to create rigorous trading approaches, in pattern recognition, and for much more.
Bollinger defines his tool as three curves plotted in and around the price structure “that answer the question as to whether prices are high or low on a relative basis.”
The bands of Bollinger changed the conception of volatility and its effect on trends in the investment markets; it added volatility as the width of the trading bands. As Bollinger recalls, in 1980 “volatility was thought to be a static quantity, a property of a security, and that if it changed at all, it did so only in a very long-term sense, over the life of a company for example. Today we know the volatility is a dynamic quantity, indeed very dynamic.”
The bands of Bollinger work best when the middle band reflects the intermediate-term trend. “So that trend information is combined with relative price level data.”
Bollinger Bands formula
When it comes to building Bollinger bands, you need to calculate the standard deviation (K) over the same number of periods (N) as the simple moving average. For the lower band, you should subtract the standard deviation to the moving average; for the upper band add the standard deviation to the moving average.
As mentioned before, the formula for the bands of Bollinger is separated into three sets of information.
- First: The middle number which consists of an N-period simple moving average.
- Second: An upper band at K times an N-period standard deviation above the middle moving average (MA + Kσ).
- Third: A lower band at K Times and N-period standard deviation below the middle moving average (MA − Kσ).
Values for N is usually 20 (Number of periods), so the moving average would be 20-periods; and for K is 2 (number of standard deviations), which is two standard deviations.
Finally, traders usually adapt the bands of Bollinger to the terms they are trading as follows:
- Short term: 10-day moving average with bands at 1.5 standard deviations
- Middle term: The default 20-day moving average with bands at 2 standard deviations
- Long term: 50-day moving average with bands at 2.5 standard deviations.
Understanding Bollinger Bands
Bollinger bands are used to identify oversold and overbought conditions as well as a relative definition of high and low. According to John Bollinger rules for his bands, “price is high at the upper band and low at the lower band”.
The closer the price is to the upper band, the more overbought the pair is. On the other hand, the closer the unit is to the lower band, the more oversold it is.
Bollinger Bands Squeeze
Now let’s talk about the Squeeze, a key component in the Bollinger Bands analysis. When the bands tighten during a period of low volatility and come closer to the middle line, it is a signal of a period of small movements, but a sharp price movement is expected. It is a hint for a market breaking opportunity. However, be careful about false moves before the real trend starts.
On the other hand, when bands separate it is considered as an indicator that volatility is increasing. However, the wider the lines are, the more possibilities for a decline in volatility is. So, it is a hint that the trend may be ending.
Breakouts are important in Bollinger Bands as 90% of price action happens between the two bands. So, any movement outside the borders is a major technical event and it is usually considered as a hint for a trend continuation. On the other hand, if prices move back after a brief adventure out of the bands, it suggests that the strength is weak.
Please be sure that you don’t use Bollinger Bands alone, as John Bollinger himself said that tags of bands are not buying or selling signals.
How to trade using the bands of Bollinger
The best way to use Bollinger Bands in Forex is to build a set of indicators that work together. For example, the indicator can be used in combination with the Relative Strength Index to generate buy and sell signals.
In the RSI case, one strategy occurs if the RSI is touching the high part of the band or the low side of the lower band, while being in an extreme condition (RSI at 100 or 0). In the case the RSI fails to touch the upper band on a second try, it signals a bearish opportunity. Also, when the RSI fails to reach the lower band, it generates a buy signal.
Finally, John Bollinger’s team also developed a set of new tools based on the original bands with at least one tool in every significant technical analysis indicator category.