In the late 1980’s a man by the name of John Bollinger created a tool to measure volatility he called Bollinger bands. Becoming a favorite among many, these bands provided a visual reference to price action relative to its mean. Although simple in concept who would have ever thought so much insight could be gleaned from this incredible indicator.
Three Important Bollinger Bands
The bands consist of a center graphing of a simple moving average (21 period), with the concomitant plotting of bands above and below representing two period standard deviations, which would represent the relative range trading has occurred.
Classical statistical analysis cannot be applied to the closing prices of investments. This results from the fact that individual foreign exchange closing prices, for example, do not follow stochastic distribution processes. This is because foreign exchange prices are not normally distributed.
The calculations in determining the standard deviations for foreign exchange prices can only be regarded as an uncertain estimate of a true standard deviation. Because prices are constantly moving depending on volatility, they cannot be viewed as fixed parameters needed for classical statistical theory. What Bollinger has done, nonetheless, is to offer a new technique to the investor to gauge volatility.
Trading Signals via Bollinger Bands
Some investors view the breaching of an upper or lower Bollinger band as a standalone trading signal in order to undertake a position. As such, these events can be awarded inordinate significance. Studies have shown penetration of Bollinger bands can occur up to 15% of the time.
Not all of these events, however, are followed by a continuation of price movement in the direction of penetration. Consequently, in order to improve performance in the trading of foreign exchange currencies, one would want to add additional confirmation signals before undertaking a position.
Popular Bollinger Band Strategies for Forex
Considering that most prices will fluctuate within Bollinger bands, many Forex traders buy when prices are near the lower range band and reverse their position when prices subsequently move to the moving average or higher.
Bollinger bands can effectively be used especially in conjunction with other indicators to determine trend reversals, as well as entry and exit points. One indicator that becomes extremely beneficial for trading foreign exchange with the use of Bollinger bands is the Relative Strength Indicator or RSI.
Using Bollinger bands with RSI confirmation, one would short the currency if penetration of the upper Bollinger band occurs, while the Relative Strength Indicator is simultaneously showing weakness. Under this circumstance, an investor would anticipate the price to fall and would exit upon reaching the lower Bollinger band or before.
One would do the opposite, if the currency price went through the lower band, and yet the Relative Strength Indicator showed strength. At this point, an investor would undertake a long position in the currency in anticipation of a minimum movement of back up to the moving average level.
There is no absolute certainty in foreign exchange trading, but with the prudent use of tools such as Bollinger bands and the Relative Strength Indicator, any individual can greatly improve performance.