Forex Trading Indicators: Using Bollinger Bands, An Absolutely Necessary Device For Technical Foreign Exchange Traders

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Forex Trading Indicators: Using Bollinger Bands, An Absolutely Necessary Device For Technical Foreign Exchange Traders

Bollinger bands on forex trading charts are used just as on equities and options trading charts, as an indicator to alert the trader to a new forming movement, breakout or trend. They are made up of three lines or bands.

The central band is a simple moving average over a certain number of periods, usually 20. The upper and lower lines are at a certain number (usually 2) of standard deviations calculated referring to the number of intervals used for the center band.

Bollinger bands were invented by John Bollinger in the 1980s. The assumption behind them is that prices will generally remain within 2 standard deviations of the average, which here is the moving average used to plot the middle line. This means that as prices reach the upper and lower band lines, a reversal is signaled to maintain the prices within the bands.

They are also an indicator of fluctuation. Wider bands indicate a more volatile market than narrow bands.

Traders use Bollinger bands in a number of different ways but these are the two most popular ones:

1. Identification of overbought and oversold market conditions

On the basis that prices are likely to stay within the bands, several traders will use Bollinger bands as an indicator to sell when the price rises above the upper line and buy when it drops below the lower line. Typically they will plan to close their trade when the price returns to the central line.

Preparedness is necessary here, however, as these movements outside of the bands could just indicate a strong trend forming in that direction. So you could be caught on the wrong side of a powerful trend in some cases. John Bollinger himself recommended all the time examining against another indicator. Most likely the most suitable for this purpose are non-oscillating indicators such as trend lines or chart patterns.

2. Identification of contraction and foretelling breakout

As we have seen, the bands will diverge and converge based on the volatility of the market over the calculated past intervals. When they converge so that their area becomes narrow, this is called contraction. Some traders will act on the basis that contracting bands is an indicator of a powerful breakout and place both buy and sell orders outside the bands.

The danger here is that there can often be a misleading break where the prices will stretch outside the bands shortly prior to reversing. For this reason some traders prefer not to act on the first move outside the bands. Again you should always check against another indicator on your currency trading charts, or use forex signals as a checking tool. A forex signal is a market forecast and a trading recommendation, which can be used as a confirmation, especially if comes from a reliable forex signal provider.

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