Why Use Bollinger Bands
Indicator in Forex Trading?
Bollinger bands will help you to predict trending movements,
act on trend reversals and finally, time trading positions with
greater accuracy for bigger profits. The Bollinger bands must
be used in combination with other trading indicators.
What are Bollinger
Bands?
Developed by John Bollinger, Bollinger bands are volatility
bands drawn around a simple moving average. You calculate
Bollinger bands using the standard deviation of price over the
same period as moving averages and plotted as lines above and
below the moving average.
As moving averages have been traditionally used to identify
the underlying trend, Bollinger bands combine this with the
volatility of the individual market (or the standard deviation)
– to plot a trading envelope.
The distance between upper and lower Bollinger bands
reflects the volatility of the currency traded.
As prices trend away from the longer-term average, the
standard deviation rises - and thus the bands will fluctuate in
varying amounts, away from the average.
Why Bollinger Bands
Work
In any market, the value of currency traded tends to rise
slowly over the longer term.
Prices may spike short term, but will normally dip back to
the longer term moving average (the centre band) - which
represents realistic value.
The volatility of the outer bands therefore gives us an
indication of how volatile prices are, and how far away
price is from longer-term value.
Most price movements are caused as much by trader
psychology, the latest economic news, and the supply and demand
backdrop - and this scenario is reflected in the concept of
Bollinger bands.
What makes Bollinger Bands so useful?
Bollinger bands perform three major functions for
Forex traders:
1. Spotting a Breakout and New
Trend
Markets move between low volatility trading ranges, to high
volatility trending moves.
When a market makes trades in a narrow range, the Bollinger
bands will narrow together and this shows a market with
extremely low volatility - however this is a warning that a
high volatility trending move is likely to follow.
When prices break above or below the upper or lower band, it
is an indication that a breakout and trend is about to develop
- traders will then take a position in the direction of the
breakout, and try to ride the trend.
2. Timing Entry Levels in a
Trend
We all know long term currency trends last for months or
years - but we need to get in at the best risk / reward
level.
Bollinger bands will help get you in to the trend and time
your entry.
All you do is watch for dips toward the centre band - and
enter in the direction of the trend.
To time your trade entries with greater accuracy, and filter
out “false” breaks use a momentum indicator - such as the
stochastic indicator, to confirm the trend.
3. Spotting Market Reversals
When the price touches the top of the band, a sell signal is
generated, and prices should revert back to the middle
moving average band.
If the price touches the bottom of the band, traders can buy
a currency, assuming that it is oversold, and will rally back
towards the top of the band.
The spacing, or width of the band, is dependent on the
volatility of the market, but gives Forex traders a clear
indication of where currency prices will go, and when to enter
a trade.
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