Bollinger Bands

What are Bollinger Bands?

Excellent range-bound indicator that measures standard deviation from the moving average.

Developed by John Bollinger, Bollinger Bands consist of three lines:

• A moving average (Often omitted in most charting packages)
• A upper band two standard deviations above the moving average
• A lower band two standard deviations below the moving average
  

Bollinger bands are an excellent range-bound indicator – meaning they work best when the market is not strongly trending, but rather fluctuating between a high barrier (resistance) and a lower barrier (support). Bollinger bands operate under the logic that a currency pair’s price is most likely to gravitate towards its average, and hence when it strays too far – such as two standard deviations away – it is due to retrace back to its moving average.

Parameters: Standard deviation of 2; moving average of 20 (usually omitted).

How it can be used:

Range-bound market.
In range-bound markets, trading with Bollinger Bands is fairly simple: it essentially involves selling at the top band and buying at the bottom one. Note how the bands are nearly horizontal when the market is in an established range. This is when reversals at the bands are more effective.

Breakouts on Volatility.
When the Bollinger bands contract (meaning grow narrower), this suggests that volatility is contracting, and that the pair is trading in a tighter range. Typically, volatility contracts right before the market makes a big breakout. Accordingly, contracting volatility – symbolized by tight Bollinger Bands – should be a sign to traders that the market may be ready to make a big break.

The chart above shows the bands have contracted to a very narrow range, preceding a breakout. Once the bands start to expand outwards, this is a signal to enter in the direction that the price is moving. So, as the chart shows, if the price is at the top of the bands and the bands start to widen, it is a signal to go long.

B. Bollinger Bands: Historical Trades
Below are two charts showing how traders can use Bollinger Bands to effectively participate in range-bound markets. Note the importance of candlesticks in validating the reversal of the trend.

As the candlestick hits the lower Bollinger Band on this daily GBP/USD chart, we immediately see a rally back to the upper band. We also see a drop to the lower band as an Evening Star formation occurs at the upper band.