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Currency Trading Charts: Using Bollinger Bands
Bollinger bands on currency trading charts are used just like on stock and options trading charts, namely as an indicator to alert the trader to a new forming movement, breakout or trend. They are made up of three lines or bands.
The central band is a simple moving average over a certain number of periods, typically 20. The upper and lower lines are at a certain number (usually 2) of standard deviations calculated with reference to the number of periods used for the center band.
Bollinger bands were invented by John Bollinger in the 1980s. The idea behind them is that prices will normally remain within 2 standard deviations of the mean, which here is the moving average used to plot the central line. This means that as prices reach the upper and lower band lines, a reversal is indicated to keep the prices within the bands.
They are also an indicator of volatility. Wider bands indicate a more volatile market than narrow bands.
Traders use Bollinger bands in a number of different ways, but the following are the two most popular:
1. To identify overbought and oversold markets
On the basis that prices are likely to remain within the bands, some traders will use Bollinger bands as an indicator to sell when the price closes above the upper line and buy when it closes below the lower line. Typically they will plan to close their trade when the price returns to the central line.
Caution is required here, however, as movements outside the bands may simply indicate a strong trend forming in that direction. So you could be caught on the wrong side of a strong trend in some cases. John Bollinger himself recommended always checking against other indicators. Probably the best for this purpose are non-oscillating indicators, such as trend lines or chart patterns.
2. To identify contraction and predicting breakout
As we have seen, the bands will diverge and converge according to the volatility of the market over measured past periods. Contraction is when they converge so that their area becomes narrow. Some traders will act on the basis that contracting bands are an indicator of a large breakout and place both buy and sell orders outside the bands.
The danger here is that there can often be a false break where the prices will stretch outside the bands briefly before reversing. For this reason, some traders prefer not to act on the first move outside the bands. Again, you should always check against another indicator on your currency trading charts.