There are several technical analysis methods you can use to track the historical range of the market, but few that can help you with multiple trading strategies. Bollinger bands, created by John Bollinger, are a technical analysis tool that not only tracks the historical range of a currency pair over time but also provides you with a gauge of volatility and momentum. Using the popular MT4 trading platform offered by Rakuten Securities Australia, you can chart forex pairs overlaying them with Bollinger bands. There are several different types of trading strategies that you can develop using Bollinger bands including mean reversion trading strategies as well as breakout-volatility trading strategies. You can also use Bollinger bands in conjunction with other technical analysis tools to provide additional confirmation that a trading signal has occurred.
What are Bollinger Bands?
Bollinger Bands are a technical analysis instrument that creates a range or band around historical prices. The trading range incorporates a band of prices the defines the high and low range that can be used for multiple trading approaches. Bands are generally used to measure a range to define a mean reversion strategy where prices revert to a specific average.
John Bollinger created Bollinger bands in the 1980s to capture the changing nature of the markets by using his bands to define historical ranges. The Bollinger bands define a specific moving average (the 20-day moving average is the default moving average in most trading platforms), that is enveloped by a certain standard deviation (the default is 2-standard deviations which incorporates 95% of all the prices).
Defining the Bollinger Bands
The Bollinger bands envelop price action using a specific standard deviation around a certain moving average. The moving average can be any period, including daily, weekly, monthly, or intra-day. The number of periods is also flexible. It can be any period from 5-units to 500-units. The longer the period, the smoother the moving average. The standard deviation captures the range of the moving average.
What is Standard Deviation?
The standard deviation is a statistical figure. The formula measures the variation or dispersion of the values in the series. For example, if you are using a 20-day moving average, the standard deviation will measure all the points over the past 20-days. A low standard deviation means that the variance around the average is small and the closing values of the data you are measuring are close together. A high standard deviation means those points are far apart. Each standard deviation measures a specific percentage of data. One standard deviation measures approximately 68% of the data points in the range. Two standard deviations measure approximately 95% of the historical prices. Three standard deviations measure about 99% of all the prices that are used to create the 20-day moving average.
How to Use Bollinger Bands
There are several ways to trade using Bollinger bands. The most common and popular is using them to envelop prices and defining a mean reversion trading strategy. This is a strategy that tries to determine how far the rubber band can stretch before it snaps back to the mean. When the exchange rate of the EUR/USD reaches the Bollinger band high, you might consider selling the EUR/USD. When the exchange rate of the EUR/USD reaches the Bollinger band low, you might consider purchasing the EUR/USD.
As confirmation, you might look for a scenario where the high of the session is above the Bollinger band high, but the close of the session is below the Bollinger band high. It could be the opposite for a buy signal where you look for a period where the exchange rate moves below the Bollinger band low but the close is above the Bollinger band low. You might also wait for a confirmation where there is a close above the Bollinger band high, and then a subsequent close below the Bollinger band high.
The Bollinger bands also show you when the exchange rate that you are evaluating is experiencing accelerating or decelerating volatility. Since the calculation of historical volatility is the standard deviation divided by the square root of time, you can use the Bollinger bands to estimate volatility. The Bollinger band high minus the Bollinger band low creates the Bollinger bandwidth. As the Bollinger bandwidth rises, volatility is on the rise, and when the Bollinger bands width declines, the historical volatility is on the decline.
When to Use Bollinger Bands
You want to use Bollinger bands when exchange rates or securities are moving sideways. This allows you to use then to capture mean reversion opportunities. The Bollinger bandwidth can help you define the market environment. When the Bollinger bandwidth is declining it means that volatility is slowing, and the market is more likely to mean revert. You can also use other technical analysis tools to help you determine if a security is trending or moving sideways.
How to Use Bollinger Bands to Signify a Breakout
The Bollinger bands can also be used to signal a breakout. When the close of an exchange rate settles above the Bollinger bands high and the Bollinger bandwidth is on the rise, an upside breakout will likely become a trend. When the close settles below the Bollinger band low, the Bollinger bandwidth is rising and a downside-breakdown is likely to occur.
Bollinger Bands are a technical analysis tool that can be used to create a band around historical prices. The trading range incorporates a band of prices the defines the high and low range that can be used for multiple trading approaches, such as mean reversion or a breakout. John Bollinger created the Bollinger bands in the 1980s to capture the changing nature of the markets. The Bollinger bands define a specific moving average (the 20-day moving average is the default moving average in the MT4 platform provided by Rakuten Securities Australia), which is enveloped by a certain standard deviation (the default is 2-standard deviations which incorporates 95% of all the prices).