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.