What Are Bollinger Bands and How Are Bollinger Bands Used in Forex Trading
Bollinger Bands are commonly used as a tool in technical analysts in a range of financial markets, including Forex. Determine the state of the market and identifying potentially profitable moves is an essential skill for traders.
Bollinger Bands demonstrate the prices and volatility over time of a given asset, which is used in a variety of trading strategies. The formula was first introduced by John Bollinger, an American financial analyst, in the 1980s. Since then, these statistical charts have been utilized to analyze the market data, inform trading decisions and manage algorithmic trading.
What Are Bollinger Bands?
Bollinger Bands demonstrate on-chart market volatility. They are two intervals drawn to predict potential volatility range for an asset, in relation to a moving average (MA). Normally, these price channels move across the chart symmetrically, but in certain market conditions, the distance between the bands varies significantly.
Bollinger Bands demonstrate on-chart market volatility.
Despite the existence of trends, there is no denying that market moves can be quite erratic. Therefore, the technical analysis applies this method for anticipating a price action. Bollinger Bands appear as three bands, the middle being a simple moving average usually plotted in a 20 minute period.
The other two bands (upper and lower) are reactive to volatility shifts and indicate the two extremes. They are calculated around the simple moving average, which will be shown below. They are drawn first and then projected into a channel that will contain the expected price changes. For trading decisions, the important pieces of information derived from the bands include the entry and exit points for trades. And unless the price moves way beyond the price channel, traders can be fairly certain about what to expect.
Bollinger Bands appear as three bands, the middle being a simple moving average, and the other two bands (upper and lower) being reactive to volatility shifts.
Some prefer to connect the top or bottom of the price to determine the upper or lower extremes. And then, they extend parallel lines to illustrate the interval of price changes.
Bollinger Bands Calculation
Bollinger Bands can be used in most timeframes – from very short-term periods, such as five-minute charts, to daily, hourly, or monthly timeframes. Traders can adjust the following two parameters: period and standard deviations (StdDev).
Traders can adjust the following two parameters: period and standard deviations.
The most used period is set to 20 but it can be modified to suit a specific need. As for the standard deviation, it is often positioned at 2.0. Consequently, Bollinger Bands denoted (20,2) indicates that the period and the standard deviation are adjusted to 20 and 2, respectively. High StdDev means that the price is less likely to reach either band. With low StdDev, the price will possibly break out of the channel.
To calculate Bollinger Bands, you need to determine the Middle, the Lower and Upper Bands separately. The formulas are as follows:
Middle Band = 20-day SMA (simple moving average)
Lower Band = 20-day SMA – (20-day standard deviation of price x 2)
Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
How to Use Bollinger Bands
The simplest way to interpret and use Bollinger bands in trading strategies is to view the channel as a measure of the highness or lowness of the price. Also, it’s important to point out that the highness or lowness is relative to previous trades.
Let's quickly go over the kind of information traders can gauge from this indicator:
- The upper band demonstrates statistically higher prices.
- The lower band demonstrates the opposite.
- The bandwidth, i.e. difference between the upper and the lower Bollinger Bands, corresponds to market volatility.
As a volatility indicator, Bollinger Bands tighten or broaden around the price plot on the chart. As seen in the formula above, the price range widens as the standard deviation goes up and vice versa. For example, when the volatility of a given currency pair is low, the channel narrows down.
Also, it can be used to confirm a trend and describe its direction and strength:
- During an upward trend, the price will continuously reach the upper band. The price reaching the upper band means the buying activity is strong.
- The trend is likely to head up, not only when it is higher the 20-period MA, but also when it goes beyond the upper band.
- In case the price is pulling back during an upward trend, it can mean two things. If it doesn’t drop lower than the SMA and goes back up, it confirms the strength of the trend. Alternatively, if it breaks the lower band, it signifies that the uptrend is reversing.
By confirming the price action, Bollinger Bands provide Forex traders with information on whether they should make buying or selling orders. For instance, a sell trade should be carried out at the upper band limit; entering a buy trade is advisable at the lower band limit. If a currency normally follows a range pattern, this method will be useful. However, mistakes can cause huge losses such as when a breakout takes place.
As a technical analysis tool, Bollinger Bands offer reassurance when traders make certain decisions. When there is trading near the outer boundaries, they can be confident there is resistance (upper band) or support (bottom band). But Bollinger Bands alone are an insufficient signal as they simply offer a perspective on the price relative to historical volatility.
5 Bollinger Bands Trading Strategies You Show Know
Having determined what Bollinger Bands, how to calculate them and what kind of information they provide, it’s time to take a look at the strategies. We have rounded up five trading strategies to showcase this trading indicator in action.
Bollinger Band Squeeze
When the distance between Bollinger Bands reaches a six-month minimum, it is identified as a Squeeze. When the volatility is that low, traders should prepare for the eventual breakout. The biggest challenge is to figure out the direction of the breakout:
Assume other indicators, such as relative strength index (RSI) along with a volume-based indicator, are heading up. At the same time, the price is going down or sideways. These are indications of a bullish market.
Alternatively, when the price goes up and the indicators are flat or making a lower top, look for a bearish breakout.
When the price takes off in either direction after this period of consolidation, the price move is often large. If it breaks through the upper band, traders need to make buy orders and vice versa. A stop-loss is preferably set on the opposite side of the breakout.
Double Bollinger Bands
First, you apply Bollinger Bands using the default parameters:
- Period: 20
- Deviations: 2
Next, the second set of Bollinger Bands should be set at slightly different settings:
- Period: 20
- Deviations: 1
These two BB indicators outline the following areas of the chart:
- A1-B1: Buy Zone
- B1-X: Neutral Zone
- X-B2: Neutral Zone
- B2-A2: Sell Zone
If the upward trend is strong, it is very likely the price will carry on moving up. Provided the candles will be closed at the topmost zone, traders should hold long trades or even enter new ones. In case the downward trend is strong and the candles close in the lowest zone, traders are advised to keep short trades or open new ones.
Bollinger Bands Scalping
This strategy takes advantage of short-term volatility in the currency. It is even well-suited for range-bound conditions accompanied by close to flat horizontal Bollinger Bands.
Here are the settings:
- Bollinger Bands are set at default parameters – 20,2.
- The best timeframes for Bollinger Bands Scalping are 1-Minute, 5-Minute, and 15-Minute charts.
- The recommended trading sessions are London, New York, and Tokyo.
- Lastly, traders can yield maximum profits by trading currency pairs with low spreads, such as GBP/USD, EUR/USD, etc.
Enter a long trade if:
- the price stays above the middle band and is drawn to the upper band
- the bandwidth widens
- the price seems to be pushed higher
The sell entry rules are the following:
- the price stays below the middle band and is drawn to the upper band
- the bandwidth widens
- The market sentiment points to the bearish movement and the price is pressured further down
Bollinger Bands & MACD Indicator
The strategy is set up to use the MACD indicator to define the trend and the Bollinger Bands to trigger the trade.
The settings for the MACD indicator should be set at:
- Slow moving average at 26
- Fast moving average at 12
- 9-day EMA as the “signal” line
The Bollinger Bands settings are:
- MA at 12
- StdDev at 2
The conditions for entering a long position are: MACD should be higher than the signal and zero lines and buy stop order should be placed at the upper Bollinger Band.
The short trade is entered when: MACD is lower than the signal and zero lines and the sell stop order is set at the lower Bollinger Band.
With this strategy, you receive accurate signals, avoid substantial streaks of losses, and have the opportunity to profit from consolidating as well as trending conditions. However, it requires you to constantly observe the charts.
This trading strategy aims to trade on reversals downward from the top of a trading range or reversals upward from the bottom of the trading range.
When to enter a long trade:
- Prices are going down inside the trading range
- Prices are tagging the lower Bollinger Band
- The bar should close higher than open, which is the Gimmee bar
- A buy order should be placed one tick above the bar
When to enter a short trade:
- Prices are rising inside the trading range
- Prices are tagging the upper band
- The bar should close lower than it opened
- A sell order should be placed one tick below the bar
It's important to note that the creator of the strategy warns traders about certain scenarios with Gimmee bars. For example, you shouldn’t trade when the bar overlaps or moves closer to the MA.
Trading with Bollinger Bands
All successful traders need to be able to determine how the markets are moving. This is why Bollinger Bands are applied – to analyze trend strength, monitor when a reversal may be occurring, and inform them if they should enter or exit the market to generate profit.
Even with certain limitations of Bollinger Bands strategies, the indicator has become one of the most useful and commonly used tools. Since the bandwidth contracts and widens with volatility, it helps traders take advantage of oversold and overbought conditions.
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