The Importance Of Bollinger Bands In FX Trading

Bollinger Bands is one of the most widely used technical analysis tools foreign exchange traders can use to better evaluate buy and sell targets. Market technician John Bollinger is credited with creating the indicator in the 1980s and the tool has certainly survived the test of time, especially as trading grew in popularity over the decades.

The Three Bollinger Band Lines

New and novice traders might be unfamiliar with the concept and how to use Bollinger Bands as part of their trading strategy. Fortunately, the concept is quite straightforward and easy to understand and can be used in the same way across all asset classes like stocks and commodities.

Essentially, Bollinger Bands is a volatility based indicator that consists of three lines on a chart, namely: 1) a middle band that represents a 20-day simple moving average (SMA), 2) an upper band calculated by adding the 20-day SMA with two standard deviations, and 3) a lower band calculated as SMA minus two standard deviations. 

The 20-day time period is the most commonly used and default metric although the band can be adjusted to adapt to a trader’s unique strategy. Bollinger Bands can automatically be added on most platforms with built-in technical analysis tools so there is no need to go through all the calculations.

Beginner’s Guide To Using Bollinger Bands

The majority of new and novice investors will use Bollinger Bands to determine potential tops and bottoms. Approximately 95% of the time, a currency will remain within the top and bottom bands as seen on a chart. So it might be wise to sell a currency when it reaches the higher band because it will likely approach overbought territory and give up some of its gains.

The same holds true on the other side of the spectrum. A technical trader waiting for a buying opportunity may find it attractive to buy a currency when it drifts towards the lower bar. Similarly, a currency that falls beyond the lower band will be considered oversold and should start to rebound higher. 

Intermediate Guide To Using Bollinger Bands

An intermediate forex trading strategy involving Bollinger Bands is known as the BB squeeze. Traders should pay attention to when the Bollinger Bands narrow or tighten and then prepare themselves for a large move in either direction.

Once traders identify a narrowing of the bands, they need to simply wait for a candlestick to break either above or below the band. This usually signals the very early stages of what is hopefully a sustainable breakout.

It is important to note that the narrowing of the bands does not offer any directional information. Placing a trade in advance of a major move is at best a 50/50 bet that goes against the use of technical analysis strategies.

Advanced Guide To Bollinger Bands

More advanced forex traders can use Bollinger Bands to identify a Double Bottom, or a W signal. This bullish pattern happens in stages as follows:

  1. A currency falls below the lower Bollinger Band.
  2. A very brief and small rebound is followed by a second move lower.
  3. The currency trades at a new lower-low but is above the lower end band.
  4. The low and lower-low resemble a “W” shape on the chart.
  5. The trader will buy the currency at this point.
  6. If the currency recovers back to the midpoint of the two extreme bands it could indicate continued momentum.

Conclusion: Not A Full Proof Strategy

No trading system is perfect, nor does it guarantee what will happen next. At its core, the bands merely offer a statistical indication to determine oversold or overbought conditions. As we know, market participants may not always react as expected.

As such, trading off Bollinger Bands should be used as a complement to a broader strategy that is constantly refined.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.