Bollinger Bands are another popular tool traders use in the forex markets and were named after their inventor, John Bollinger, in the 1980’s. They remain an incredibly clever tool for analyzing volatility as well as being good measures of trend and momentum.
Bollinger Bands are made up of two levels (bands) that are placed two standard deviations above and below the simple moving average of the market. The simple moving average used is normally the 20 day moving average hence the usual configuration of ‘20,2,2’ when setting up the bands. However, these settings can be changed according to the user’s preference.
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How do Bollinger Bands work?
By being two standard deviations away from the average price, the bands provide a relative definition of what is high and what is low and therefore provide indication as to whether the market is oversold or overbought. They also do a good job adapting to different market conditions.
Mean reversion
The most obvious way to use Bollinger Bands in a trading system is to sell the market when it touches the upper band and buy the market when the price touches the lower band. Since these levels show that the market is high or low compared to the mean, it is likely to move back sooner or later. Traders can either look to the middle moving average line to take profits or wait till the market moves to the opposite band.
Breakouts
Another way to use Bollinger Bands is as part of a trend following strategy. In this scenario if the price closes outside of one of the bands, it can be said that a breakout has occurred. This shows significant strength and indicates that the market is likely to carry on this direction for a while. Thus, if the market closes above the upper band, a trader should enter a long position on the next open. Conversely, if the market closes below the lower band, a trader should enter a short position. The moving average middle line can then be used as an area to place a stop.
Volatility
It is also possible to use Bollinger Bands in a volatility system by watching for times when the Bollinger Bands are either very close together or very spaced apart. Often, when markets are quiet, Bollinger Bands will come together in a pincer motion. When this happens, it is almost always a sure fire signal that the market is about to explode either up or down.
Similarly, if the market has recently experienced a lot of volatility and the bands are very far apart, you can bet your life that the market will settle down and move into a move reliable range in the near future. In this way, you can use Bollinger Bands to help trade options.
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