How To Trade Using Bollinger Bands

Bollinger bands are statistical chart envelopes set at standard deviation on top and below a simple moving average used to characterize volatility and prices of a commodity over time.

Bollinger bands use period and standard deviation as parameters. The value of the period is 20 and that of the standard deviation is 2 but you are free to customize the value combination at your choice.

Bollinger bands are used on a relative basis to determine how high or low the prices are. The upper and lower bands are used in pairs in relation to a moving average.

Bollinger bands

The term Bollinger is derived from John Bollinger, the man who came up with the Bollinger bands in the 1980s. Bollinger bands are charts that show the volatility and price of commodities over a period. Three arithmetic calculations determine Bollinger bands:

  • The moving average of the closing price.
  • The moving average of the closing price and adding standard deviations from it.
  • The moving average of the closing price and subtracting standard deviations from it.

Bollinger bands have several characteristics. The most common ones include:

The Bollinger squeeze

When a break out is imminent, the bands are squeezed together. During an upward break out of candles towards the top band, the trend usually continues upwards. However, if the break out of candles is downwards towards the lower band, the trend continues downwards.

Volatility is said to be high when the Bollinger bands are far apart, and volatility is low when the Bollinger bands are close together.

A Bollinger squeeze is said to be triggered when volatility reaches six months low. This can be determined when after six months the Bollinger bands reach the minimum distance apart.

According to John Bollinger, the creator of the Bollinger bands, the best Bollinger band setting is between nine and twelve.

When using such settings, you will notice the upper Bollinger band shows clearly an upward trend and the prices of the trading commodities are always constantly in contact with the upper Bollinger band.

During an uptrend, the gap between the upper and lower Bollinger bands will widen indicating rising price volatility. When the gap between the upper and lower Bollinger bands narrows, this indicates a fall in price volatility.

The Bollinger bounce

In a Bollinger bounce, the prices start high and candles on an upward breakout trend. Suddenly, the prices drop, and the candles go on a downward breakout. This forces the trader to wait for the bands to bounce back to the middle.

This method of trading is best used when there is no clear trend and when the market is ranging.

You are advised to avoid trading using the Bollinger bounce method if the bands are in an expanding trajectory. This is because if the bands are expanding, it means the prices are moving in a trend rather than within a range.

A pivot line bounce happens at the pivot zone. The pivot zone is where prices are bound by the range within the daily trading range.

The pivot zone is made up of resistance lines acquired by calculating the previous day’s range of trading.

The possibility of a price bounce is higher and is determined when prices approach a pivot than the chances of a cross through.

Bollinger and RSI (Relative Strength Index) 

Introduced in 1978 by J. Welles Wilder, Bollinger and RSI attempts to highlight the past and current strengths and/weaknesses of a share or trading commodity. This is achieved by analyzing the closing prices of recent and specific trading periods by measuring the momentum, magnitude, and force of price.

You can use the relative strength index with Bollinger by looking out for when the prices hit the lower band and the relative strength index hits the oversold region (below 30). These would be the optimal entry prices to buy.

In case you want to sell, you are advised to wait for the prices to hit the upper band and the relative strength index reaches the overbought region (above 70).

Conclusion

Forex is not for the easily bored. To be able to trade successfully, you have to love numbers. The terms highlighted above are some of the most commonly used terms in trading forex. By understanding the terms used in the trade, you will be better placed to make informed trading decisions likely to influence your bottom line positively.