Today, forex trade is among the most lucrative trading markets in the world. Traders exploit fluctuation in currency exchange rates by selling or buying the currency to make a profit. Bollinger bands enable forex traders to enter or exit market positions by identifying points when a currency is oversold or overbought. Forex traders use this tool because it is effective and straightforward to use.
What are Bollinger Bands?
Bollinger bands are a kind of statistical chart that characterizes the volatility of the market and the variation of prices over time of a commodity or a financial instrument using a formula formulated by John Bollinger in the 80s. In the chart, the Bollinger bands create a zone covering the trading bars.
A trader should look for three distinct lines on a trading chart- the upper and lower line located in the upper and lower bands, respectively. Between these two lines is the simple moving average. The area between the lower and the upper line from the simple moving average is the standard variation. It is known as the bandwidth.
Forex trade is very volatile. The bandwidths of the bands determine this volatility. The market is more volatile when the bandwidth is large. The vice-versa is also true. Most traders are keen on low volatility, which is indicated by a narrower bandwidth because it signifies an upward or downward explosive trend. As a new trader, it is essential to know that Bollinger bands work best when used with other indicators.
Bollinger Band Trading Rules
There are a few points that you should note when using Bollinger bands to trade. Although Bollinger bands are highly versatile, these rules can guide you in your future interaction with the chart. These rules include:
Upper Bollinger bands indicate a high price, while the lower band indicates a lower price. A trader should use these highs and lows to compare price and indicator action and decide whether to buy or sell.
For instance, use more than one indicator, one derived from open interest and the other from volume or momentum. You should make sure that you use different ones to prevent them from relating to each other directly. For instance, you can use a momentum indicator with a volume indicator but not two momentum indicators simultaneously.
The tags of the band are not signals for selling or buying. They are just tags, while the closes outside the bands are continuation signals, not reversal signals. The moving average and standard deviation have default values of 20 and 2, respectively.
The moving average describes the market trend in the intermediate term and is used to calculate the standard deviation.
Traders should not use the standard deviation calculation to make statistical predictions because the price distribution will be abnormal, mainly because bands take a minimal sample size to make calculations.
Bollinger bands are most effective when used in combination with other indicators.
Bollinger Bands Application in Forex
Traders use several trading strategies to make a profit in forex trade using Bollinger bands. Some of those strategies include:
The Bollinger Bounce
The simple moving average shows the trader where the prices normalize. Traders who use Bollinger bounce have come up with different systems to help them use bounces to make profits. These systems work best when the market is ranging without a clear trend. Bollinger works best when the bandwidth is contracting or just stable.
The Bollinger squeeze occurs when the bandwidth contracts and the top and bottom bands squeeze together. The Bollinger squeeze is used to indicate an imminent breakout. When the candle pokes through the bottom band, it shows an imminent downward trend. Long periods of contractions indicate a volatile market that could experience an explosive break out. It, therefore, allows traders to spot moves as early as possible.
The Bollinger bands enable traders to identify the areas of great value. However, they do not indicate the weaknesses or strengths behind the price moves. A trader cannot rely on these bands to predict a continuous trade trend outside the outer band or mean revert. However, using Bollinger with another indicator such as RSI maximizes its prediction and analysis value.