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Currency Trading Charts: Using Bollinger Bands, An Essential Tool For Technical Foreign Exchange Traders
Bollinger bands on currency 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 middle band is a simple moving average over a specific number of periods, typically 20. The upper and lower lines are at a certain number (usually 2) of standard deviations plotted with reference to the number of intervals used for the center band.
Bollinger bands were invented by John Bollinger in the 1980s. The idea behind them is that prices will predominantly alternate within 2 standard deviations of the average, which here is the moving average used to plot the central line. This means that as prices reach the upper and lower band lines, a reversal is expected to keep the prices within the bands.
They are also an indicator of amplitude. Wider bands signal a more volatile market than narrow bands.
Traders use Bollinger bands in a number of various ways but these are the two most widespread ones:
1. Identification of overbought and oversold markets
On the basis that prices are likely to alternate within the bands, some traders will use Bollinger bands as an indicator to sell when the price soars above the upper line and buy when it dips below the lower line. Typically they intend to close their transaction when the price returns to the central line.
Attention is important here, though, as these movements outside of the bands may just indicate a strong trend unfolding in that direction. So you could be stuck on the wrong side of a strong trend in some cases. John Bollinger himself advised always examining against another indicator. Probably the most effective for this function are non-oscillating indicators such as trend lines or chart patterns.
2. Identification of contraction and predicting breakout
As we have seen, the bands will diverge and converge based on the volatility of the prices over the measured 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 significant breakout and place both buy and sell orders outside the bands.
The risk here is that there can often be a false break where the prices will expand outside the bands briefly prior to reversing. For this reason some traders rather do not act on the first move outside the bands. Again you should always check against another indicator on your forex 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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