Foreign exchange markets can move all over the place. Sometimes quickly shifting from a strong bullish and bearish price action. Such market movements become less mysterious once traders start to realize that people move the markets. Therefore, the nature of the market reflects besides estimates based on research also a lot of human emotions as feelings, beliefs, fears, and greed. One of the best technical indicators that reflects these human emotions in the market are Bollinger Bands.
Bollinger Bands (BB) are volatility bands that are placed above and below a moving average. In financial markets volatility is closely linked with riskiness. Volatility is nothing more than the standard deviation of a security. When prices move heavily up and down the standard deviation spikes up; and so does volatility. The Bollinger bands automatically widen when volatility increases and narrow when volatility decreases. The BB can be used for different purposes. We will start off simple and move into more detailed features of the BB.
The Bollinger Bands consist of three elements:
- An N-period moving average (MA)
- An upper band at K times above the moving average (MA + K*σ)
- An lower band at K times below the moving average (MA – K*σ)
Where σ is standard deviation. Standard values for N and K are 20 and 2. Although it is suggested by John Bollinger that trader should adjust their standard deviation values (K) according to the moving averages they use. He suggests using 2.5 times the standard deviation if people use a moving average of 50-periods, and 1.5 for short 10-period moving average.
On a chart it will look like this (using standard BB values). Important to notice that the bands widen once the market gets more volatile.
Incorporating Bollinger Bands into trading
How traders use the BB varies widely. Some trader prefer to buy a currency pair when it touches the lower BB and exit when price moves back to its moving average in the center. Others trade focusing on price breakouts of the BB. A third category of BB-traders look for M-top and W-bottom patterns to occur.
Price breakouts on the BB occur pretty often. Probably many traders would immediately think of 2 times the standard deviation on a normal distribution would give a confidence interval of roughly 90-95%, making a breakout a rare event. Unfortunately financial markets are not normally distributed and a breakout of price happens often. Especially when important news updates hit the market or just a strong up- or downtrend. According to John Bollinger a move above or below the bands is not necessarily a signal, but rather “tags”. The way traders should think these tags like with a momentum oscillator. Overbought is not necessarily bullish. Getting to the BB takes strength and they can stay there for quite a while if the uptrend is strong.
W-bottom form in a downtrend and involves two reaction lows. According to John Bollinger especially W-bottoms where the second low is lower than the first, but holds above the lower bands are powerful reversal patterns. In order for the W-bottom pattern to complete 4 steps needs to be confirmed:
- A reaction low is formed. This low usually comes below the lower band, but not necessarily
- Price bounces back towards the middle band
- A new price low is formed. This low holds above the lower band. This is a sign indicating less weakness on this last decline in price.
- The pattern is completed with a strong move off the second low and breaks the resistance which is at the previous swing high (between the two bottoms).
A similar pattern as the W-bottom, but only indicating a potential reversal from bullish to bearish is the M-Top. Generally a M-top pattern is similar to a double top, only are the reaction highs not necessarily equal. When looking for trading opportunities with this pattern it is important that you look for other signs of non-confirmation that price is making new highs. Non-confirmation occurs in three steps:
- Price forms a reaction high that is above the upper-band
- We get a pullback towards the center MA
- A new top, which is above the prior high is formed. Only this top fails to reach the upper-band. This signals that momentum is waning.
- The final confirmation comes with support (previous pullback low) is broken.
Personally I don’t keep BB on my chart the whole time. A disadvantage is that they make your chart look less organized. That doesn’t matter that they provide traders great opportunities. The BB with 20-period simple moving average (SMA) reflect the direction of the market combined with the volatility. The combination of SMA with volatility bands makes it easy to quickly determine if price is relatively high or low. Traders should use BB in combination with basic trend analysis and other indicators to find confirmation.