Bollinger Bands are a favorite indicator for online traders for multiple reasons. One, they are visually interesting and resemble a river meandering across a chart. Two, they give decently reliable signals of where prices might reverse, although like all indicators, they are not infallible and the upper, lower and center bands they display are based on past price, so like the Fibonacci retracement, Bollinger Bands are referred to as a “trailing” or “lagging indicator.” They effectively supply an inkling to trend, as well. Bands dropping to the right indicate a downtrend; Bands rising indicate an uptrend. Horizontal bands reveal a dormant market, suggesting a time to avoid trading. The other reason Bollinger Bands are widely used is that they offer an effective means by which to confirm the validity of other indicators and signals.
They are known as an “overlay indicator” because they appear on the time/price grid itself, as opposed to, for example, a stochastic indicator that would be in a separate window.
A Brief History of Bollinger Bands
John Bollinger invented the trading tool that bears his name in the 1980s. He has refined them over the years and as recently as 2010 released additional indicators based on the original Bollinger Bands. Prior to powerful personal computers, that automatically perform all the necessary calculations to display bands on a price chart, traders had to do the calculations manually, which required some intermediate math skills.
The Bollinger Band Tool in Trading Platforms
Bollinger Bands can be used on price charts for any period, but they seem to perform better on longer periods, beginning with at least an hour. Selecting the tool from the list in the trading platform, the trader is given certain options. One of these is “standard deviation.” The default setting in most trading platforms is two standard deviations, which most traders gladly accept. A setting above two will probably produce bands that are so far apart that prices never touch the upper and lower bands. Less than two standard deviations will squeeze the bands so close together that prices will almost constantly be outside the bands.
The other main option is “periods,” where the trader decides how many price candles or bars to use in order for the calculations. The default is typically 14, meaning that on an hourly chart, the last 14 hours of prices will be used for the calculations. This setting is easy to personalize, using the Bollinger Band tool in, for example, the trading platform of AlfaTrade. Many traders like to experiment with different periods, similar to what they might use for a moving average indicator, setting the period to 50, 100 or 200.
There are other options, mostly cosmetic, relating to the color of the bands, the thickness of the lines, or whether or not to display the middle band.
Trading Forex with Bollinger Bands-Interpretation
It is possible to use Bollinger Bands more than one way. Some traders will trade completely within the bands, buying when prices touch the lower band, selling when they touch the upper band and exiting trades when prices touch the opposite band from where they entered the trade. Other traders will wait for prices to break outside the bands, selling when the lower band is broken and buying when the upper band is broken. Still others will wait for a band to be broken, and then wait one more price bar or candle to see if prices return to the Bollinger Band channel. They then enter long or short positions, exiting those positions when prices touch the center band. Some experienced Forex traders combine the approaches, dependent on the currency pair or the period being used.
Other Bollinger Band Considerations
Like all lines on a price chart, the upper, lower and center lines of Bollinger Bands need to be given some space above and below the band, indicating a range of prices. For many Forex currency pairs, on intermediate time frame charts, thinking of the band as being about eight pips wide is effective.
Another good use of Bollinger Bands is to determine the relative volatility of a currency pair. When the upper and lower bands are far apart, prices are swinging quickly. When the bands are close together, prices will be quieter. When bands start very far apart and then constrict together, it could be a sign of rapid and dramatic price change.
Bollinger Bands can be an effective indicator, if traders take some time to gain experience with them and observe when they give good signals or when they are not as reliable. They tend to fail more often in quiet markets.