Bollinger Bands is a popular technical indicator that traders have been using for decades. Most notably, Bollinger Bands survived the test of time because the statistics and math behind making a more informed trading decision have not, and never will change.
This is an informative guide on what Bollinger Bands can do and how traders can use it to improve their odds of success.
Introduction To Bollinger Bands
Bollinger Bands appear on any chart and offer a visual guide related to the magnitude of a currency’s direction, identify potential shifts in the direction, and monitor volatility.
The bands on the chart consist of three easy to understand lines. The middle line represents a moving average of prices, in most cases calculated over the past 20 days but this can be customized to a trader’s individual needs. An upper band, as the name implies, is found above the moving average line and is calculated by combining the moving average plus two standard deviations.
The lower band is the last of the three bands. This line is calculated by taking the moving average and subtracting two standard deviations.
Fortunately, the vast majority if not every charting software or trading platform will offer the bands as a default option. The software will do all the calculations in the background so traders don’t need to worry about the complex math.
What It All Means
Bollinger Bands can be interpreted and used in multiple ways but many traders use it to determine the strength or weakness of recent trading action. If a currency is running hot, it will likely touch or trade near the upper band at which point traders would start to close their position. If it fails to do so, it might signal the end to recent momentum and could be interpreted as a selling point for traders ahead of a possible reversal.
Not following what the bands are signaling could result in a profit quickly turning into a loss.
Most traders would agree that once a currency trades below the middle band, it is fresh out of momentum. Currencies undergoing a strong uptrend should never hover near the lower band as this would in fact signal a reversal in direction is underway.
Similarly, a currency that is losing value amid heavy trading action will likely touch or hover near the lower band. If it fails to do so, it could signal the bearish sentiment is in the very early stages of reversing. This could signal a buying opportunity as the downward trend will be followed up with a bullish move.
A currency showing weakness should never trade near the upper band. If it does, it may be safe to assume that any prior weakness is officially over.
Not A Perfect Indicator
No technical or fundamental analysis tools will offer traders a foolproof strategy. Such a tool simply doesn’t exist because the market often acts irrationally and catches even the most disciplined traders off-guard.
Bollinger Bands is no different. In fact, the creator of the band, John Bollinger, doesn’t like to use his own tool as part of a stand-alone system. He recommends traders complement the Bollinger Bands analysis with two or three other indicators.
One of the other indicators that many Bollinger Band supporters use is the Relative Strength Index (RSI). The RSI is a common indicator that indicates if a currency is statistically overbought or oversold. The RSI is measured on a scale of zero to 100 and an RSI value above 70 indicates overbought conditions while an RSI under 30 is oversold.
Bollinger Bands are never meant to act as a perfect indicator, rather it is a tool that incorporates statistics and math with prior trading data. Even when used under ideal situations, it could still result in a losing trade.
If a new trader isn’t seeing success with Bollinger Bands it could either be attributed to not understanding how the bands work or a series of bad luck. Disciplined traders that are able to rationally look back at their trading history to identify mistakes and missed opportunities should be able to easily figure out which one of the two it is.