Bollinger bands are a technical indicator developed by John Bollinger in the 1980s to measure whether prices are high or low in relation to market volatility. Most forex traders use Bollinger bands to determine whether volatility is increasing or decreasing in order to better time trades based on trend reversals. Bollinger bands are also known as envelopes because they envelope a forex chart while contracting and expanding according to the price action on the chart. Bollinger bands are classified as a trend-following indicator because they combine a moving average indicator with a currency pair’s volatility.
Bollinger bands are made up of two outer bands and a middle trend line, which is a moving average from which the other bands derive their values.
Upper band = middle band + 2 standard deviations
Middle band = 20-period simple moving average (SMA)
Lower band = middle band – 2 standard deviations
EURUSD chart with 20-period bollinger bands
It is important to note that the price of a given currency pair rarely strays below or above the Bollinger bands as in most cases, the bands will contain the price action in a given chart.
It is advisable to stick with the default Bollinger bands settings provided on most charting software packages as most traders are also using the same values to make their trading decisions.
The distance between the upper and lower Bollinger bands typically expands whenever there is high volatility and contracts whenever volatility decreases. Remember that in most financial markets, periods of low volatility are usually followed by periods of high volatility.
The 20-period SMA line at the middle of the Bollinger bands is a central defining band as the areas above and below the middle band are treated very differently.
The region above the 20-period SMA or middle band is referred to as the buy channel and when prices are in this area they typically indicate that an upward trend is underway. The region below the middle band is known as the sell channel and when prices are plotted in this area, they typically indicate that a downtrend is ongoing.
Despite the fact that many traders prefer to trade the strong trends, you should be aware that markets only trend about 20% of the time. If they trade wisely, traders can make substantial gains by making trades within the bands based on the educated assumption that prices will ‘snap’ back to the middle band.
Whenever a chart is in an uptrend or a downtrend, you can wait for reversals to the middle bands and then profit from the continuation of the trend. Although you will not profit from the entire move, you will still profit from part of the trend, which is quite good for conservative traders.
Whenever the Bollinger band is tightly grouped around a currency pair (otherwise known as being squeezed) for a period, it has to break out of the ‘squeeze’. However, we cannot predict the time when it will break out of the squeeze or even the direction in which it will break out. There are two ways in which we can trade such a squeeze.
The first method is where you place two stop orders in opposite directions that will be activated once the price breaks out of the squeeze. You can set up the two orders such that when one is activated the other order is automatically cancelled, or you can cancel it manually.
Another way to trade the squeeze is to wait for the price to break out of the squeeze before initiating your trade. In this scenario, you wait for the price to break out and then reverse back and touch middle band (the 20-period SMA). You should place your trade once the price starts heading back in the direction of the breakout.
Many newbie traders often make the mistake of selling or buying a currency pair once the price breaks out of either the upper or lower Bollinger bands, expecting the trend to reverse. However, you should not fall into this trap as, in many cases, the price of a currency pair might stay above the bands for a long period. John Bollinger clearly stated that breaks above or below the bands should not be regarded exclusively as reversal signals.
You could, however, capitalize on situations where the price is trending above the Bollinger band by initiating trades in the direction of such a trend. For example, if the price has broken above the upper Bollinger band and has stayed above the band for some period, this could be the set up for a major bullish trade.
Remember that you could use pullbacks to the SMA line at the middle as opportunities to add to your position if the price continues with its initial trend. You should prepare your trade exits whenever the price action starts to lose momentum and fails to continue accelerating outside the Bollinger bands.
It is important to remember that no indicator is fool-proof and that you should always use good risk-management practices with Bollinger bands or any other indicator. That said, Bollinger bands are a versatile indicator that can be used by traders for multiple purposes, especially for measuring volatility.