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Understanding Bollinger Bands (Part II)
Bollinger Bands are based on the standard deviation. A standard deviation is the measure of the spread of a set of number. The higher the difference between the closing prices of a currency pair and the average price, the larger the standard deviation and the volatility of the currency pair. 95% of the recent closing prices are expected to be within the two standard deviations of the currency pair when the markets are range bound. In a range bound market, in other words, if the price pops above or below the Bollinger Bands, it does not belong there.
The formula used to calculate the Bollinger Bands (BB) is: Lower BB= 20 SMA-2(Standard Deviation) and Upper BB= 20SMA + 2(Standard Deviation. There are three different ways you can setup trades using Bollinger Bands.
Range Trading: In a range bound market, these envelop lines or bands are parallel to each other. You can consider trading within the range identified by the Bollinger Bands. You can use the bands to enter or exit a trade.
When the price reaches the upper band, the market is considered to be overbought. When the price touches the lower band, the market is considered to be oversold. However, when the price touches the upper band or the lower band, it in itself is not a trading signal.
Do not predict a support or resistance level based solely on Bollinger Bands. You are seeking opportunities to profit not opportunities to trade! Wait for the price to bounce first and seek confirmation from other indicators before you enter a trade. Once the reversal pattern is confirmed by other indicators, you can place your stop loss on the other side of the Bollinger Band.
Breakout Trading: Suppose the price breaks above or below the upper or lower band. This is an indication that a breakout and a new trend is about to develop. Seek confirmation by using a momentum indicator such as the 5 EMA/8 SMA cross or a stochastic cross. This will filter out a false breakout. If the price breaks above the resistance on the upper band, enter a long trade. If the price breaks on the downside on the support level, enter a short trade.
Tunnel Trading: When you see the Bollinger Bands becoming tight and narrow, expect a breakout to occur in the near future. The longer and more narrow the Bollinger Bands, the greater the breakout will be. Pay attention! This is only true between the times 5 A.M to 5 P.M London Time.
When tunnels are created during the odd hours of currency trading, it simply shows that no one is trading at that time! Most of the traders are out and a breakout is not likely to happen until the traders return to their charts. This is also known as the, Bollinger Band Squeeze. The Bollinger Bands spread further apart and is an excellent indication to plan a trade. When a breakout happens, a new trend is started.
About the Author Mr. Ahmad Hassam is a Harvard University Graduate. He is interested in day trading and swing trading stocks and currencies. Discover A Revolutionary New Forex Robot. Develop your own Forex Trading System.
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