Monday, April 23, 2012

Bollinger Bands

Bollinger Bands – a simple yet powerful indicator, ideal for traders who like visual style of trading.

Bollinger Bands: quick summary

Created by John Bollinger, the Bollinger Bands indicator measures market volatility and provides a lot of useful information:

- trend direction
- trend continuation or pausing
- periods of market consolidation
- periods of upcoming large volatility breakouts
- relative market tops and bottoms and price targets.

Bollinger Bands interpretation

Bollinger Bands indicator consists of three bands, which 85% of the time retain price within their boundaries:

- Simple moving average (SMA) in the middle (with default value of 20)
- Lower band - SMA minus 2 standard deviations
- Upper band - SMA plus 2 standard deviations

The default value for Bollinger Bands in Forex is (20,2) - the settings we'll be using for our screenshots.

When the market becomes more volatile, the bands will correspond by widening and moving away form the middle line. When the market slows down and becomes less volatile, the bands will move closer together. 

How to trade with Bollinger Bands

Price moves in upper bands channel – uptrend, lower - downtrend

It is very simple to identify dominating price direction by simply answering the question: in what part of the Bollinger bands the price is currently trading? If price stays above the middle line – in the upper channel – we’ve got a prevailing uptrend. If below the middle line – in the lower channel – we have a prevailing downtrend.

 And just in case you’ve missed the beginning of the trend, Bollinger bands can help you get in the trend with good risk to reward ratio on a pullback.

Simply look for dips towards the middle Bollinger bands line and enter in the direction of the trend.

Low volatility, followed by high volatility breakouts

When Bollinger bands start to narrow down to the point when they are visually forming a neat tight range (measured no other way than by eye), as shown on the screenshot below, the situation signals of an upcoming increase in volatility once market breaks outside the bands. It is similar to a quiet time before the storm. 

The more time passes while price is contained within the narrow Bollinger bands range, the more aggressive and extensive breakout is expected.

 Price moves outside the bands – trend continuation
When price moves and closes outside the Bollinger upper or lower bands, it implies a continuation of the trend. With it Bollinger bands continue to widen as volatility rises.
But it is not always straight forward: at some point closing outside Bollinger bands will mean price exhaustion and upcoming trend reversal.

Bollinger bands alone are not able to identify continuation and reversal patterns and require support from other indicators, such as often RSI, ADX or MACD – in general all types indicators that highlight markets from a different than volatility and trend prospective (momentum, volume, market strength, divergence etc).

 Trend reversal patterns with Bollinger bands

As a rule, a candle closing outside Bollinger bands followed later by a candle closing inside the Bollinger bands serves as an early signal of forming trend reversal. It is, however, not a 100% assurance of an immediate trend reversal.  
Since long aggressive trend develop not that often, there will be on general more reversals than continuation cases, still only filter signals form other indicators may help to spot true and false market tops and bottoms.

Speaking of the last, Bollinger bands are also capable of aiding double top and double bottom pattern recognition and trading.

W and M patterns with Bollinger bands

A double top or M pattern is a sell setup. With Bollinger bands it occurs when the following sequence take place:

- price penetrates the lower band,
- pulls back toward the middle line,
- a new subsequent low is formed, and this low is above the lower band and never has touched it.
- a setup is confirmed when price reaches and crosses the middle Bollinger line. 

In fact, a very conservative trading approach requires price to cross and close on the other side of Bollinger bands middle line before the trend change is confirmed.

As you have probably noticed, the middle Bollinger bands line is simply a 20 SMA (default) line. This Simple Moving Average (SMA) is by itself a widely used stand alone indicator, which help Forex traders identify prevailing trends and confirm trading signals.


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