How to use Bollinger Bands to trade Forex
Technical indicators are one of the most important tools used by traders. A good technical indicator helps traders know the best time to enter and exit a trade. There are lots of good technical indicators used by various traders in the trading sector. This text will be focused on the Bollinger bands. We will discuss what a technical indicator is, how to use it, calculate it, and some good trading strategies.
What are Bollinger Bands?
Bollinger Bands are technical indicators that were founded by John Bollinger. The technical indicator is a price envelope that defines the high and low price range levels. Bollinger Bands are price envelopes illustrated at an average level in between a simple moving average of a price level. The distance between the bands depends on the standard deviation, they adapt to the momentum of the trade in the fundamental price.
Bollinger Bands utilize 2 parameters, the standard deviation, and the Period represented as StdDev. The most popular parameters used by traders for the periods and the Standard deviation are 20 and 2 respectively. However, the parameters can be customized according to the trader’s trading strategy.
Bollinger bands help determine whether prices are high or low on a relative basis. They are used in pairs, both upper and lower bands, and in conjunction with a moving average. Additionally, the Bollinger Bands are not to be used in isolation, they should be used together with other trade signals.
How does the Bollinger Bands Indicator work?
Just like every other technical indicator, it involves the use of a simple moving average.
Bollinger Bands are made up of three lines: the lower band, the middle band, and the upper band. The middle line is the simple moving average, and the parameter is picked by the trader. The low and the upper bands are placed on opposite sides of the moving average band. The trader chooses the parameters of the standard deviations, and then picks the distance between the moving average and the upper and lower bands. The position of the upper and lower bands indicates the trend of the trade. It shows if the trend is strong and the probable low and high price points of the trade.
When the band contracts during a low volatility period, it indicates a price reversal in the opposite direction. Which indicates that the price will reverse to the opposite side. However, traders are advised to watch out for a false breakout on the opposite side, as a false breakout quickly reverses before starting the original trend.
When the band expands it shows an increase in volatility and it also indicates the end of an existing trend. Prices sometimes bounce between existing bands, that is prices touch existing bands briefly. These price swings indicate potential profit targets. For instance, when the price of trade moves from the lower band and crosses over the middle band, this means the upper band is a potential price target.
Price can surpass a band or stay on a band for a long time during high momentum. The continuation of a strong trend is indicated when the price of trade moves away from the bands. However, prices move back within the bands once the indicated trend is neutralized.
Bollinger Bands Formula
The Bollinger bands formulas were derived from the theory of the concept of trading bands. It involves two trading bands that are replaced around a simple moving average identical to the envelope technique.
To explain in detail,
The number of periods is the moving average (MA)
The upper band is represented as K which is the standard deviation over the moving average. (MA + Kσ).
The lower band K is the number of periods of standard deviation under the moving average. (MA – Kσ).
The parameters often used for N and K are often 20 and 2. Generally, Simple Moving Average is likened to Exponential Moving Average because it is utilized in estimating the volatility used in assigning the bandwidth, therefore, it is important to use the same average when choosing the parameter for the center point.
However, the same periods are used in estimating the middle band and the standard deviation. For a 20-day average, the most current 20 days are used.
Also, note that a Standard Deviation is a statistical theory that explains how prices are distributed over an average value. The significance of utilizing two standard deviations is that it guarantees that 95% of the price information will plunge between the two trading bands.
The most used parameters for Bollinger Bands are 20-day periods and ± 2 standard deviations. Traders who start with the default parameters should reduce that bandwidth to 1.9 standard deviations when using 10 periods, but when using 50 days periods it should be increased to 2.1 standard deviations. However, the most important strategies are market evolution.
How to calculate Bollinger Bands?
Firstly, estimate the simple moving average, and estimate the standard deviation using the same number of periods with the simple moving average.
To estimate the upper band, sum up the moving average to the standard deviation.
To estimate the lower band, minus the standard deviation from the moving average.
Bollinger Trading Strategies
How to use Bollinger Bands to trade Forex
Numerous trading strategies can be used with the Bollinger band technical indicator. Let’s evaluate them in detail.
TRADING BULLISH TRENDS WITH BOLLINGER BANDS
Trading using the Bollinger bands can be utilized to pinpoint how the momentum of a trade. And the momentum used during its price reversal. If trade shows a high momentum, it will touch the upper band regularly. When a bullish trend touches the upper band it indicates that the asset is rallying and traders can take advantage of the opportunity to generate profits.
When there is a pullback in the bullish trend, and the price stays on top of the middle band and crosses over to the upper band, it indicates a high momentum. A trending trade should not reach the lower can’t when the price touches the lower band, it indicates that the price might be getting ready to reverse or lose momentum.
Many technical traders take advantage of the bullish trends to generate profits from a trade. This is done before a reversal occurs. Once a trending stock fails to attain a new high, traders always see that as a warning sign and start selling. They sell off the asset to avoid losing their already generated profits propelled by a price reversal. Traders use the technical indicator to analyze the price trend of an asset and also know its strength and weakness.
TRADING BEARISH TRENDS WITH BOLLINGER BANDS
Using Bollinger Bands to trade bearish trends can be used in specifying the momentum of the trade when the price is falling. It is also used to specify the momentum of the trade when it’s reversing to an uptrend. During a strong bearish trend, the price will stay at the lower band, and this indicates that sellers are in control of the market. But when the bearish trend does not touch the lower band, it shows a diminishing momentum in the bearish trend.
In a case where the price touches the middle band and falls below the middle band, it indicates a loss in bearish trend momentum. During a bearish trend, prices do not touch or break through the upper band. When this happens it indicates a trend reversal or a reducing bearish trend momentum.
Most traders stay away from downtrends, but rather, they wait for a trend reversal before buying an asset. A bearish trend can last for years, months, weeks, days, hours, minutes, days, or seconds. Trades need to constantly analyze the market to know the best time to open or exit a trade. However, if the bearish trends persist, traders are advised to protect their funds by using tight stop loss and take profit orders. Traders are also advised against entering long-term trades during long bearish trends.
TRADING W-BOTTOMS AND M-TOPS
W-bottoms and M-Tops are used by traders to specify the patterns with a fundamental W-pattern and M-pattern, respectively. Bollinger bands use W patterns to determine W-Bottoms when the second bottom is lower than the first bottom but hangs over the lower band. It happens when a low is formed beside or under the lower band.
The price of the asset reverses close to the middle band or above it and forms a new low that supports the lower band. But when the price of an asset moves over the high of the first price reversal, the W-bottom is formed and is illustrated in the chart. This indicates that the price of the asset is but to reverse to a bearish trend.
The M pattern was used by John Bollinger with Bollinger Bands to identify M-Tops. An M-Top is identical to a double top chart pattern. This pattern occurs when there is a price movement towards or above the upper band. The price of the asset declines falling towards the middle band or under. This forms a new high but does not stop above the upper band.
BOLLINGER BANDS SQUEEZE STRATEGY
This is another strategy used by traders using the Bollinger Bands. The squeeze strategy occurs when the price of an asset is rising aggressively and then begins to move sideways in rigid price consolidation.
Traders use this strategy to specify when the price of a trade is consolidating. When this occurs the bands contract together. This indicates a decline in trade volatility. It shows that the trade is not trending, it is neither up nor down. After trending sideways, the price always makes a bigger move either up or down, with high volume. When the volume of a trade increases as price breaks out, it shows that traders are in charge of the price trend, and it’s going trend in that direction for a while.
When the price moves past the lower or upper band, the trader either sells or buys the asset respectively. A tight stop-loss order is set outside the price consolidation on the other side of the breakout.
Limitations of Bollinger Bands
Bollinger Bands are notably technical tools that assist traders in making good trade judgments. However, just like every other technical tool, there are a few limitations traders need to know to learn How to use Bollinger Bands to trade Forex.
- Primarily Bollinger bands are reactive and predictive. This means that the bands are more reactive to changes in the price of an asset. That is, the bands react more to uptrends and downtrends but do not predict the future outcome of a price movement. The band does not predict the price of an asset. Just like most technical indicators, Bollinger bands are a lagging indicator. This is because the tool is based on a simple moving average, which generates its average price from several price moves.
- Even though traders use the bands to evaluate trends, they can’t use the indicator in isolation in the prediction of price. It is advisable to use the indicator in corroboration with other technical tools. Using the Bollinger bands with two or three more tools will help provide a more accurate reading. For price predictions, traders should use a trade signal in conjunction with the Bollinger bands.
- Bollinger bands technical tool settings do not default. That means what works for trader A might not work for trader B. Traders need to personalize their settings to help them set plans for the particular asset they’re trading. If the picked band settings do not provide good results, traders can modify the settings or use another technical tool. The efficacy of Bollinger bands alters from one market to another; these traders have to modify settings even when trading the same asset over a period.
Bollinger Bands are used by traders for different reasons. So How to use Bollinger Bands to trade Forex? Traders use Bollinger Bands for overbought and oversized strategies. Traders can also incorporate several bands into the technical indicator to help ascertain the strength of the force trends. Another method of utilizing the Bollinger bands is by looking out for volatility contractions. These instructions are fundamentally accompanied by vital price breakouts, basically with high intensity.