How to use Bollinger Bands

Bollinger Bands

A Form of Envelopes

Bollinger Bands are envelopes that surround the currency prices on a chart. Envelopes are simply symmetrical lines parallel to a moving average, where the moving average is the centre of the trend, and the envelope consists of the points of maximum and minimum divergence from it. Bollinger band is a popular method of interpreting the moving average concept.

The Gist of Bollinger Bands

Bollinger bands are calculated as standard deviations above and below a moving average, commonly set to 20. Since the standard deviation is a measure of volatility. the Bollinger bands adjust themselves to market conditions. The banks widen as the price trend becomes more volatile, and narrow during less volatile periods.

Figure 1 shows an hourly chart of USD/JPY, with the green band as the upper Bollinger band, the yellow band as the lower Bollinger band, and the middle purple line as the 20-moving average.

Figure 1

When the bands contract, it signals a period of low volatility, whereby demand and supply are in a fine state of balance, and neither bulls nor bears are in charge. Narrowing signals a tendency for sharp price movements to follow. If the price breaks out of a band, the trend is expected to continue.

When the price exceeds the upper band, it means the upside momentum is strong enough to support higher prices, and the same is true for a price breakout of the lower band. Very often, the currency price will cross back into the envelope, and this crossover signals short-term exhaustion before the trend continues again. Sometimes, the price will crossover for the last time before the trend reverses.

One way of spotting a possible trend reversal is when the currency pair tries several times in attempting to break out of the upper or lower band but fails, and in the process, forms a reversal chart pattern, such as a Double Top or Bottom. The added weight of evidence seeks to alert the trader of a potential reversal ahead.

How to Use Bollinger Bands in Currency Charts

Bollinger bands do not generate buy and sell signals alone. They should be combined with other technical indicators such as MACD or price patterns to give a better overall technical picture of the currency pair.

Bollinger bands do not work well during trending phrases, just like momentum indicators. If you look at Figure 2, you see that when the trend moves persistently in one direction, which in this case is a downtrend, touching the lower band does not offer a timely signal because the band progressively turns lower together with the price declines.

Figure 2

If you have other technical indications of a currency price trend, it is possible to use the bands as areas to enter the trend. For example, if technical indicators and market sentiment favor a downtrend, you may enter a short position when the price moves to the upper Bollinger band, as shown in the hourly chart of USD/JPY in Figure 3. Note that the sloping down of MACD at the bottom of Figure 3 indicates that a downtrend is in place.

Figure 3

As mentioned earlier, after the currency price has broken out of a band, it will soon cross back into the envelope, and this crossover very often signals a short-term pause in the trend, as opposed to a trend reversal. As such, it may be a good idea to take profits when the price moves back into the band after breaking out earlier on.

Figure 4 shows the price has broken out of the upper Bollinger band in an hourly chart of USD/JPY, and MACD is sloping upward at the same time. It may be a good place to take a profit when the price falls back into the band again, as indicated by the arrow.

Figure 4

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