Lesson 7 – Bollinger Bands

Written on 10 November 2008 by Staff

Bollinger Bands where first developed by John Bollinger during the 1980s. Bollinger Bands enable traders to know if a currency price is high or low or overbought or oversold. The upper band is the limit that defines high prices, while the lower band defines lower prices.

Bollinger bands will contract and expand depending of the elasticity of prices in relation with the pair’s price. Bollinger bands use the standard deviation measure, which is used to figure out the spread of prices around the “true price”.

A common practice for Forex traders is to use Bollinger Bands to define overbought and oversold levels, selling when price touches the upper Bollinger band and buying when it hits the lower Bollinger band. Although this technique could work in range-bound markets, it usually triggers false signals.

When a pair’s price touches the bands, it DOES NOT MEAN there is a signal. Prices often may and will go just a bit over and under the upper and lower bands. In these markets, traders who continuously try to “sell the top” or “buy the bottom” are faced with a series of stop-outs or worse, sometimes they leave open losing positions with the hope that a trend reversal may occur. Big Mistake!

A smarter way to use Bollinger Bands to trade has something to do with trends, but first you will have to understand that at the core, Bollinger bands measure deviation. This is the reason why they can be very helpful in diagnosing trend.

If two sets of Bollinger bands the following way:
The first Bollinger Bands set at ONE standard deviation
The Second Bollinger Bands set to use TWO standard deviations,
Then we can define this smarter trade component for a strategy.

When price moves between the upper Bollinger Bands (+1 SD and +2 SD) away from the mean, the trend is up, therefore, we can use these areas to start a long trade, as long as prices remain in these areas. (White Area)

And if price moves within the lower Bollinger bands (–1 SD and –2 SD), the same as above applies but in a short trade. As you see in the following example, since it is an uptrending market the white area is marked, but no trade is taken.

Finally, if price just move between +1 SD band and –1 SD band, prices are not heading anywhere for that moment, so your best bet is to stay put and to NOT take any positions for the moment, unless you have confirmation of your strategy with other indicators.

It is always important for you to remember that NO trade should be taken be the signal of one indicator alone. All positions are best confirmed with various technical or fundamental indicators and candlestick patterns.

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