Trading Forex with Bollinger Bands

The Bollinger Band indicator was developed by John Bollinger and are used in Forex trading. The Bollinger Bands is considered a trend indicator that uses trading bands similar to envelopes. There are two bands on either side of a moving average. The outer bands add and subtract a standard deviation calculation that measures the volatility of price and ensures that 80% of the price remains within the bands.

As volatility increases the bands expand, as it decreases the bands contract. The basic premise of Bollinger Bands is that price should remain within 2 standard deviations (outer bands) of the mean which is the center line moving average. The center line is a 20 period moving average and acts as the trend indicator. When the market is above the MA it is trending long and when it is below the moving average it is trending down.

Bollinger Bands are used to measure volatility and give traders an indication of how high or low prices are relative to the recent past. They are also used to identify overbought or oversold conditions in the market represented by the two outer bands. A touch of the upper band represents overbought and a touch of the lower band represents oversold.

There are two main methods of trading with Bollinger bands, namely the Bollinger bounce and the Bollinger squeeze.

Bollinger Bounce

We anticipate that reversals will normally occur at or near the upper or lower Bollinger bands. Many traders use these outer bands as entry points in a ranging market to enter a reversal trade.

When price closes outside either the upper or lower bands we enter a trade in the opposite direction. It is assumed that when a trade is entered at one extreme it will continue to the opposite extreme or outer band and become our exit point when price starts to retrace from the opposite band. These mini support and resistance lines become our exit and entry points for the trade.

During ranging periods it is possible for the market continue in a particular direction without a significant widening of the bands. Price will generally stay above or below the center line, close to the outer line. In these instances it would be prudent to combine another indicator as a filter before attempting a reversal trade.
 

Bollinger squeeze

Periods of low volatility cause the bands to contract and narrow. This is generally followed by rapid expansion, a large rally and new trend. This trade is normally identified by a candle or bar penetrating an outer band and a rapid widening of the outer bands.

Many traders believe the first break of the outer band is a fake out and wait for the second break to occur before entering the market. When these breakouts occur the candle or bar will normally penetrate an outer band and price will stay outside of the outer band.

We are aware that in general price remains within 2 deviations of the mean therefore within the confines of the bands 80% of the time and when price remains outside of the expanded bands a strong trend is in tact. We therefore stay in the trade until a candle or bar opens inside the bands before exiting.

As with all indicators false signals are generated and the Bollinger band is best used in conjunction with another indicator to act as a filter.

Bollinger Band Chart Example

(Click on the chart to enlarge)