Bollinger Band is a tool used by technical analyzers, and defined by several trendlines that are plotted on a standard positive and negative deviation, away from an SMA (Simple Moving Average) of the price of securities, but is adjustable to a user’s preference.
John Bollinger, a technical trader developed and patented the Bollinger Bands. The bands were designed to identify opportunities that allowed investors to get a higher chance of identifying when assets were overbought or oversold.
Bollinger Bands are described best as on-chert volatility indicators. They comprise upper and lower bands that react to volatility changes. When a currency pair’s volatility is high, the band’s distance increases, and when volatility is low, the two bands come closer together.
How to Use Bollinger Bands
Although the Bollinger Bands are a volatility indicator, they are very useful in identifying support and resistance areas. The indicator comprises of three lines, of which, each demonstrates resistance or support functions. The two Bollinger lines are usually better for demonstrating resistance and support. The Bollinger Bands can generate some signals, which respond to a variety of price changes on the charts.
1. Bollinger Band Squeeze
When the Bollinger Bands condense, the trading indicator tells you that the Forex pair’s volatility and the trading volumes are low. The pair is not trending, but ranging or consolidating. This is called a Bollinger Band Squeeze since the bands are being squeezed or tightly condensed. In such cases, traders should avoid trading within such tight consolidations or ranges because there are fewer chances of profitable trades, compared to trending stages.
A crucial concept that traders should grasp in forex is that prices move from low volatility periods to high periods, and the pattern repeats. After a squeeze, prices break out and slide into a downtrend. The breakout of the Bollinger Band squeeze provides a solid reason to enter the market when the prices rise beyond either band. This provides support for the range-bound market ending and the possibility of prices going into a new trend stage.
2. Price Touching Lower Band
When the price touches the lower band, it is a Bollinger Band signal that indicated prices are low or oversold. This means a bullish bounce might happen, which creates an opportunity for long trading. If the price starts to quickly fall at the lower band, the distance between the two bands becomes bigger, and traders must be wary of going into a long trade.
When the bands expand, there is a strong price momentum under the lower band, this is an indication of a bearish bias.
3. Price Touches Upper Band
A similar scenario is in play, but in opposing directions. The upper band is seen as a hidden resistance level that premises on a strong volatility reading. If the bands expand, causing the price to close candle after candle atop the upper band, traders should expect a more bullish increase.
4. Bollinger Bands Move Average Breakout
The Bollinger Bands Moving Average breakout is a strong indication that comes after the price interacts with the bands. If the price moves from the upper band, breaking the 20-period SMA towards a bearish direction, a strong short signal is sent.
If the price moves from the lower band, breaking the 20-period SMA in an upward direction, a strong and long signal is sent. In the same manner, a 20-period SMA breakout can set exit points after a Bollinger Bands trade.
Limitations of the Bollinger Bands
Bollinger Bands are helpful tools but have some limitations.
· Bollinger Bands are Reactive
Bollinger Bands are not predictive but are reactive instead. The bands react to any price movements but do not predict prices. Traders must use these tools with other tools that offer direct market signals.
· Standard Settings Not for All
The standard Bollinger settings do not favor all traders. A trader must find settings that let them set their guidelines for the stock they are dealing with. If the chosen bands do not work, a trader has the freedom to change the settings or change the tool. Bollinger Bands’ effectiveness differs from market to market, and traders may have to alter the settings, whether or not they are trading one security over a long period or not.
It is important to remember that Bollinger Bands trading strategies are not part of fundamental, but are more technical analysis. This means the variables of technical analysis are derived from the newest price action and does not consider factors like relative Purchasing Power Parity Levels or interest rate differentials. The Bollinger Bands are therefore not the best tools to identify under and overvalued currencies.