[FOREX TIP] Bollinger Bands Technical Strategies

Bollinger Bands Technical Strategies

Bollinger Bands are a very popular technical indicator which measures the price volatility of a financial instrument. Bollinger Bands are invented by the famous technical analyst John Bollinger in the 1980s, and trademarked by him in 2011. Bollinger Bands are showing the volatility of the price by plotting two bands, the upper and lower band, two standard deviations away from a simple moving average (SMA). In general, when the market becomes more volatile, the bands widen, and in less volatile period the bands become narrower. If the bands become narrower and track parallel for an extended time, the price will usually bounce of the upper and lower bands, which take a role of support and resistance lines in sideways trading conditions. Let’s take a look at some popular strategies which involve the Bollinger Bands.

The Squeeze

When the bands come very close together, and the distance from the moving average becomes very small, it is called a squeeze. This market condition implies very low volatility, and traders should be prepared for a possible increase in future market volatility and trading opportunities. The opposite situation, in which the bands are wider apart, means that the market volatility is very high. In this case traders should prepare for a decrease in volatility and eventually consider exiting a position. The following chart shows a squeeze with a succeeding rise in price volatility.

 

The Breakout

A breakout occurs when the price closes outside the upper or lower band. This situation is very rare, as 90-95% of all market activity is taking place inside the bands, so far as the standard setting for the standard deviation multiplier is used (K=2). A breakout is therefore a major event, but it doesn’t provide a complete trading signal, because the future direction of the price or time when a breakout will occur are unknown. Therefore, John Bollinger suggests using other direction-based indicators for entering a trade. The following chart shows a fake breakout:

Some traders also use a breakout for entering a trade. Because the bands act as support and resistance lines, a breakout of the price outside these bands is considered a potential trading possibility. In the next chart, we show a breakout trade setup on EUR/GBP, with Bollinger Bands (20,2).

 

 

 

 

 

In the beginning of December 2015, the price moved outside the upper band with a long bullish candlestick. To confirm the breakout, a trader should wait for a second signal, which in this case give the following candlestick patterns. The next period after the breakout, a small black candlestick appears, with high and close prices inside the previous candlestick’s body. This is the first signal showing the dominance of buyers. The next period, forming a bullish long-shadow candlestick, and with a close just on the border of the upper band, confirms once more that an uptrend is possibly ahead. Now it is time to enter a long position.

The pair trades the next few months close to the upper band, with a few fake breakouts, and touches quite often the middle band, i.e. the 20-period moving average. The position should be closed either when the price falls to the lower band, or the trend shows signs of exhaustion. In this case, the price failed to make a new higher high on the 24^th of March 2016, forming a double top with the upper band acting as a resistance level. This is a level where trader would consider exiting the position.

Riding the Bands

Another popular strategy based on Bollinger Bands, is riding the bands. During powerful down and uptrends, the price tends to stick to the lower and upper bands, respectively. This shows that there is still enough steam behind the trend, and that it will likely continue in the future. As mentioned before, plotting the bands two standard deviations away from the moving average, means that almost 90-95% of the price-action is contained inside the bands. A price sticking to one of the bands, is therefore a major statistical event which happens in exceptional conditions, like changes in the currency fundamentals.

The chart above shows the EUR/GBP pair on H4 timeframe. On 20^th of August 2016, the price broke the previous high and traded outside the upper band for a while. Opening a long position after the break of resistance would give the opportunity to ride the upper band, as the price has touched the upper band until 25^th of August. After the price closed away from the band, traders should close the long position with a nice profit in the account.

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